Risk Management Strategies: The Sortino Ratio
In trading, risks are a constant demon.
The first thing you have to start thinking about before trading is about your risk management strategy. When you already have one, it helps you cut down losses, and it protects your account from losing money.
Risk management is an essential prerequisite to successful trading, but often than it is appropriate, it is overlooked.
The Sortino ratio: What is it?
The Sortino ratio is used to measure the risk-adjusted return of an investment asset, strategy, or even a portfolio. It is known as a modification of the Sharpe ratio, but this one penalizes only those returns that fall below a user-specified target or required return rate.
The Sortino ratio is a way to compare the risk-adjusted performance of programs with differing risk and return profiles. In other words, the Sortino ratio takes a portfolio or asset's return and subtracts the risk-free rate. Later it divides that amount by the asset's downside deviation.
This method or formula is used everywhere around the world and has proven a solid scale of efficiency when it comes to measuring risk.
The formula and using it
- The formula for the Sortino Ratio is: (Rp-rf)/σd
- Rp is equal to the actual or expected portfolio return.
- rf is equal to the risk-free rate.
- σd is equal to the standard deviation of the downside.
Using these values and their properties, we can make statements such as the likelihood of losing any money, even though we can't see negative returns. We can also determine the range within which two-thirds of all returns lie.
When it comes to this formula, a higher Sortino ratio result is better. When searching at two similar investments, a rational and professional investor would prefer the one with the higher Sortino ratio.
As an example, assuming Mutual Fund X has an annualized return of 12% and a downside deviation of 10%. The Sortino ratio for this mutual Fund will be:
Mutual fund X: (12%-2.5%)/(10%) = 0.95%
If you have another Mutual Fund to compare it too, and the result is a higher number, then that one with the higher Sortino rate is the better investment choice.
What do you learn from the Sortino ratio?
By using the Sortino ratio formula, you can score a portfolio's risk. It measures the adjusted returns relative to an investment target using the downside risk.
The Sortino ratio centers only on the negative deviation of an asset's returns, and it is made to give a better view of the performance since positive volatility is a benefit.
Two different ratios: Sortino and Sharpe
Both rates are risk-adjusted evaluations of return when it comes to investments. The Sortino ratio is a variation of the Sharpe ratio that only factors in downside risk.
The Sharpe ratio is calculated by subtracting the rate of return from an investment considered risk-free. The Sharpe ratio also indicates how well an equity investment is performing compared to a risk-free investment.