The Sortino ratio is a way to measure the risk adjusted return of an asset, investment portfolio, or trading strategy. The Sortino ratio is an adjustment to the Sharpe Ratio that filters volatility from upside moves from downside moves. The Sortino ratio only measures downside moves that are below a specified volatility target or return expectations as negative.
The Sharpe ratio punishes the up and down moves in price volatility equally with no filter for direction even when it is in an investors favor. Both the ratios have metrics for risk adjusted returns but have different filters for ways to measure both the risk and the efficiency of generating returns with risk and draw downs.
The Sortino ratio is a tool for comparing returns by contrasting them with risk exposure. It is a good measure for comparing different investments and trading systems. The goal of the Sortino ratio is measuring the risk adjusted returns across assets and normalize the risk exposure and then see which asset has the most return per dollar of risk.
When the rate of return distributions are nearly symmetrical and the return goals are close to the median distribution, the two measures will create very similar results. As variance increases and volatility targets move from the median, results can be expected to show dramatic differences in the way they measure volatility is different. The Sortino ratio does not punish volatility to the upside and in the investors favor while the Sharpe ratio penalizes all volatility as negative for the investor.
The Sortino Ratio formula is (R) – Rf /SD
(R): Expected return
Rf: Risk free rate of return
SD: Standard deviation of the Negative Asset Return