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Sortino Ratio
Portfolio Thinking and Governance Framework
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Sortino Ratio
Sortino Ratio: only bad risk The Sortino Ratio is an improved version of Sharpe, which accounts only for negative volatility. Developed by Frank Sortino to solve the main drawback of the Sharpe — "punishment" for positive surprises.
Key Idea Investors are not afraid of upside volatility — they fear losses. If an asset grows by 50% in one month and by 3% in another, Sharpe "punishes" for the first month. Sortino does not.
Formula Sortino Ratio = (Rp - Rf) / σd σd (Downside Deviation) — volatility of only negative returns Only periods are counted when Ri
Calculation of Downside Deviation σd = √[Σ min(Ri - MAR, 0)² / n] All positive deviations are zeroed, only negative ones are counted.
Sharpe vs Sortino: practical example Two funds over a year (monthly returns):
| Month | Fund A | Fund B |
|---|---|---|
| January | +2% | +15% |
| February | +1% | -3% |
| March | +3% | +8% |
| April | -1% | -5% |
| May | +2% | +20% |
| June | +1% | +2% |
| Metric | Fund A | Fund B |
|---|---|---|
| Average return | 1.33% | 6.17% |
| Total volatility (σ) | 1.37% | 9.58% |
| Downside Deviation (σd) | 0.58% | 2.89% |
| Sharpe (Rf=0) | 0.97 | 0.64 |
| Sortino (Rf=0) | 2.29 | 2.13 |
Conclusion: Sharpe shows that A is better than B. Sortino shows that they are almost equal — volatility of B is mostly "good" (growth).
When Sortino is especially important
- Cryptocurrencies — extreme volatility, but often upward
- Venture investments — most deals are unprofitable, but rare "unicorns" give 100x
- Options strategies — selling puts has low overall volatility, but high downside risk
- Momentum strategies — periods of strong growth alternate with sharp drops
- Emerging Markets — asymmetric return distributions
Interpretation of Sortino values
| Sortino | Assessment |
|---|---|
| Loss-making strategy | 0 - 1 |
| 1 - 2 | Good ratio return/downside risk |
| 2 - 3 | Excellent strategy |
| > 3 | Exceptional (check for hidden risks) |
Limitations of Sortino
- Choice of MAR — which threshold to consider "bad"? 0%? Rf? Inflation?
- Few data — if negative periods are few, σd is unstable
- Does not account for magnitude of losses — -1% and -30% "weigh" differently, but Sortino does not fully capture this
Combined analysis Professional CIO uses both metrics together:
| Situation | Sharpe | Sortino | Interpretation |
|---|---|---|---|
| Both high | ↑↑ | Ideal strategy | |
| Sharpe low, Sortino high | ↓↑ | Volatility is "good" — consider | |
| Sharpe high, Sortino low | ↑↓ | Dangerous! Hidden downside risk | |
| Both low | ↓↓ | Avoid |
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