If you have read our article on the Sharpe Ratio
, you probably noticed that conceptually the Sortino Ratio is very similar to the Shape Ratio.
The main difference between Sharpe Ratio and Sortino Ratio lies in the definition of volatility.
In the Sharpe Ratio volatility is measured through the standard deviation of the returns of the financial instrument. This means that both positive and negative swings are included in the volatility.
However, does it make sense to consider positive swings in risk? In some cases yes, in others no.
Generally speaking, when we talk about risk we are talking about drawdowns, price drops. Since the Sharpe Ratio is unable to capture the difference between positive and negative fluctuations, the Sortino Ratio was introduced.Contrary to what happens for the Shape Ratio, in which both positive and negative fluctuations are included in the term “risk”, for Sortino Ratio risk is measured by taking into account only negative fluctuations.
This makes the Sortino Ratio more suitable for determining the actual risk and, consequently, evaluating the risk-return ratio.
But how does the Sortino Ratio work specifically? How is it calculated?