Sortino Ratio

The Sortino ratio improves upon the Sharpe ratio by distinguishing between harmful downside volatility and beneficial upside volatility. It only penalizes returns that fall below a target or minimum acceptable return.

Formula: Sortino Ratio = (Portfolio Return - Target Return) / Downside Deviation

Sortino vs. Sharpe Comparison:

Feature	Sharpe Ratio	Sortino Ratio
Volatility Used	Total (up + down)	Downside only
Penalizes Upside?	Yes	No
Better For	Symmetric returns	Asymmetric returns
Preferred When	Normal distribution	Skewed returns

Interpreting Sortino Ratios:

Sortino Ratio	Interpretation
< 0	Negative excess return
0 - 1.0	Below average
1.0 - 2.0	Good
2.0 - 3.0	Very good
> 3.0	Excellent

Why Sortino Is Often Better: A strategy that has occasional large gains (upside volatility) gets penalized by the Sharpe ratio but not by the Sortino ratio. Since investors only care about downside risk, the Sortino ratio provides a more accurate picture.

Example:

• Fund A: 12% return, 15% total std dev, 8% downside dev → Sharpe: 0.53, Sortino: 1.00
• Fund B: 12% return, 10% total std dev, 9% downside dev → Sharpe: 0.80, Sortino: 0.89
• Sharpe prefers Fund B, but Sortino prefers Fund A (less downside risk)