If you want to invest in something, you should not only think about the rate of return. It is better to also think about the risk. The risk can be high or low. It refers to how different an asset’s or security’s financial performance will be than what is expected.
Unfortunately, many performance metrics do not account for the variation in risk of investing. They calculate how much money they will make.
But when it comes to the Sortino ratio, it has a different way that it is calculated. The indicator is looking at changes in the risk-free rate. That way, investors can make better-informed decisions. It becomes really helpful because it helps investors to reduce the risk.
In this article, we are going to look at what the Sortino ratio is, how it works and why it is different from other performance measures.
What is the Sortino Ratio
The term “Sortino” was named after Frank Sortino, who was a former head of the Quantitative research group at Bell Investment. He was a pioneer in promoting a risk-adjusted return.
So what is this ratio
The Sortino ratio is different from other ratios because it focuses on downside risk instead of the overall return. It measures how well the investment does in regards to the risks that are involved. That makes it a valuable tool for investors who want to reduce risk in their portfolios.
The formula for the Sortino ratio is as follows
Sortino Ratio = (Average Realized Return – Expected rate of Return) / Downside Risk
How does the Sortino Ratio work
To calculate the Sortino ratio, you will need to know what is called the downside deviation. This is how much an investment will vary from its expected value regarding risk. It can be expressed as a negative number.
The downside deviation is not always possible to know exactly because it will require having specific market data at hand. It is also difficult to measure because there are many different ways that it can be presented over a certain period.
What the Sortino Ratio does is to decrease this downside deviation by focusing on high, positive returns. That way, you will get a ratio that is increasing whenever a portfolio’s performance actions move more advantageously.
What makes the Sortino Ratio different from other ratios
Some factors make the Sortino ratio different from other performance measures.
The first is that it reduces the effects of volatility on returns. The traditional way of measuring an investment’s success was to look at its return over a certain year, which can be misleading because there can be negative returns. But by subtracting this downside risk and focusing on positive returns, the investor can get a more accurate picture.
Another thing is that it helps in identifying periods when investments are doing well regarding risk. This gives investors an idea of when they will need to reduce risk in their portfolios or limit losses. It also shows you what impact different market conditions have on your portfolio’s performance.
The last factor is that it has a great way of benchmarking. It can compare how well an investment or portfolio is doing against another that uses different return and risk criteria.
Why use the Sortino Ratio
There are several reasons why you should think about using the Sortino ratio for your investments. Here are they:
- It helps in assessing risk and returns
The Sortino ratio is a great way to compare an investment’s return and its downside risks. That makes it easier to determine whether the investment is good for you or not.
- It’s useful when making decisions
It will help you make important decisions about your portfolio, such as switching out investments that are bad performers. It will also help you make other certain adjustments to make sure that your portfolio can improve its overall performance.
- It’s a great way to compare investments
The Sortino ratio is especially useful for investors who want to compare different types of investment portfolios with each other. You can use it as an initial step when investing and it will help you know what kind of risks the investment is involved in.
Conclusion
The Sortino ratio provides investors with a more accurate way of measuring investment performance. It helps in assessing how well an investment is doing regarding its risk factors and it can be very useful when making other decisions about your portfolio.
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