Use the Sortino Ratio to Gauge Downside Risk in Your Portfolio

You’re investing part of your savings over the next three years for a down payment on a home or possibly your child’s first year of college. The right investments can help you meet your goals faster—but you realize you can’t take the risk of significant market losses setting you back.

How can you tell if an investment you’re looking at has a track record of avoiding downside volatility, better known as potential losses?

The Sortino ratio, named for economist Frank Sortino and his investment work in the early 1980s, may help guide you in the right direction. The Sortino ratio only uses annual downside volatility of the investment in its calculation, giving you a clearer picture of an investment or portfolio’s risk-adjusted return.

If you have a relatively short investment time horizon (say three years), downside risk is all the more important to your investment decisions. The Sortino ratio can help you measure this against returns, so you know how much risk you’re potentially taking on. Remember, though, as with most market calculations, the Sortino ratio uses historical data to produce a result. Past performance is no guarantee of future results.

What is the Sortino ratio?

The Sortino ratio is one of the key metrics of risk-adjusted performance used by professional portfolio managers. (For some others, check our earlier coverage on the Sharpe ratio and the Information ratio.)

The Sortino ratio is a variation of the Sharpe ratio. While the Sharpe ratio measures returns as a function of total volatility (gains and losses), the Sortino ratio is built to focus on weighing the returns given the potential for downside risk. 

According to Viraj Desai, director, portfolio manager at TD Ameritrade Investment Management, LLC, “You’ll see (the Sortino ratio) most frequently used by investors who have a lower risk tolerance and a generally short investment time horizon—less than three years, for example.” He added, “Those with longer-term investment time horizons may bypass the Sortino ratio and focus on the Sharpe or Information ratios for a broader idea of upside and downside risk. But in short-term investment situations where goals are near, investors would do well to pay closer attention to the Sortino ratio.”

How to calculate the Sortino ratio formula

The Sortino ratio begins with an investor’s desired minimum acceptable return they want to beat based on their risk tolerance and investment time horizon.  

For example, investors may choose from a range of variables to plug into the equation, including Treasury rates, inflation, federal funds rate, or in the case of some professional portfolio managers, a client-specified return referred to as the minimal acceptable return (MAR) they need to meet or beat.

For uniformity’s sake, we’ll make the lower-risk rate in the equation the 10-year Treasury note (TNX) yielding about 3.75% as of early June 2023. Here’s how that equation would look.

Sortino ratio formula = (Rp – Rf) ÷ Downside deviation

Key:

• Rp: Portfolio return (actual or forecast)—this is the investment’s current annual return, and you’ll find it in the fund’s fact sheet or prospectus.
• Rf: Risk-free rate—the lower-risk rate of return you hope to beat, usually a U.S. Treasury yield.
• Downside deviation: This is a measure of the investment’s volatility on the downside. A lower downside deviation implies less volatility in tough markets and consequently a higher Sortino ratio. A higher downside deviation implies more risk and leads to lower Sortino ratios. You’ll typically find this data in the investment’s fact sheet or prospectus. 

What are the limitations of the Sortino ratio?

As with most any portfolio calculation, the Sortino ratio has limitations investors should be aware of:

• The Sortino ratio is calculated using historical performance data, which may not hold up in the future. Investors would do well to view the Sortino ratio as a snapshot of that investment’s potential loss risk based on the latest market data available.
• By emphasizing the downside, the Sortino Ratio neglects upside potential.
• Because the ratio is a little more difficult to calculate and has more assumptions baked in, it is not as widely used as say the Sharpe Ratio.  
• Even though the Sortino ratio is seen as a useful barometer for risk-averse investors with short time horizons, most experts note that using less than three years of historic data can weaken the validity of its calculation. Added Desai, “10 years’ worth of data is ideal for the Sortino ratio because it will encompass an entire business cycle.” 

The bottom line

Combined with the other two risk-adjusted metrics (Sharpe ratio and Information ratio), the Sortino ratio focuses on the downside risk profile of an asset over time. The Sortino ratio can be especially useful for investors with a low risk tolerance or a short-term investing time horizon, so they may want to pay closer attention to the fund’s Sortino ratio than a long-term investor might.