Quick Summary
- The Sharpe Ratio measures total volatility to show how much excess return an investment earns per unit of overall risk.
- The Sortino Ratio focuses only on downside volatility, making it better for evaluating conservative or income-focused portfolios.
- Sharpe Ratio formula: (Average Return тАУ Risk-Free Rate) ├╖ Standard Deviation of Returns.
- Sortino Ratio formula: (Average Return тАУ Risk-Free Rate) ├╖ Downside Deviation.
- Use the Sharpe Ratio for balanced portfolios with both upside and downside volatility, and the Sortino Ratio when you want to measure returns against downside risk only.
Both the Sharpe Ratio and Sortino Ratio help investors measure how efficiently returns are earned relative to risk, but they donтАЩt view risk the same way. The Sharpe Ratio considers total volatility, while the Sortino Ratio focuses solely on downside risk, providing a truer picture for conservative investors.
In this blog, weтАЩll break down how these two ratios differ, when to use each, how theyтАЩre calculated, and what they reveal about investment performance and risk management.
What Is the Sharpe Ratio?
The Sharpe Ratio measures the relationship between an investmentтАЩs returns and its volatility. A higher ratio means the investment provides better returns relative to its risk level.
Importance of Evaluating Investment Performance
The Sharpe Ratio helps investors assess whether higher returns are due to smart investing or just excessive risk-taking. A higher ratio indicates better risk-adjusted performance. Whereas a lower ratio suggests returns may not justify the level of risk.
What Is the Sortino Ratio?
The Sortino Ratio measures returns earned above the risk-free rate relative to downside deviation (volatility below a target or minimum return).
Importance of Assessing Downside Risk
The Sortino Ratio is preferred when evaluating investments where upside volatility isnтАЩt a concernтАФsuch as long-term funds, low-risk portfolios, or income-focused strategies. It offers a more accurate reflection of true risk-adjusted performance for conservative investors.
How It Differs from the Sharpe Ratio
While the Sharpe Ratio uses total volatility (both upside and downside), the Sortino Ratio only considers downside volatilityтАФpenalising investments for losses rather than gains.
Sharpe Ratio vs Sortino Ratio
Both the Sharpe Ratio and Sortino Ratio are used to assess risk-adjusted returnsтАФhow efficiently an investment delivers profit relative to the risk taken. However, they differ in how they define and treat risk.
The Sharpe Ratio considers overall volatility, while the Sortino Ratio focuses only on the losses investors actually want to avoid.
| Aspect | Sharpe Ratio | Sortino Ratio |
| What It Measures | Overall risk (total volatility of returns) | Downside risk (only volatility below a target return) |
| Formula | (Average Return тАУ Risk-Free Rate) ├╖ Standard Deviation of Returns | (Average Return тАУ Risk-Free Rate) ├╖ Downside Deviation |
| Focus | Penalises both upward and downward volatility | Penalises only negative returns |
| Best Suited For | Broad investment comparisons тАФ mutual funds, ETFs, or portfolios with symmetrical risk | Conservative or income-focused portfolios where downside protection matters |
| Interpretation | Higher ratio = better risk-adjusted performance across all volatility | Higher ratio = better downside protection with steady returns |
How to Calculate the Sharpe Ratio
The formula to calculate Sharpe ratio is:
Sharpe Ratio = (Average Return тАУ Risk-Free Rate) ├╖ Standard Deviation of Returns
Where:
- Average return is the mean return of the investment over a specific period.
- Risk-free rate is the return of a low-risk benchmark (e.g., government bond).
- Standard deviation measures volatility or total risk of returns.
Profitability Ratio Measures & Applications
When to Use these Ratios
- Ideal when assessing low-risk or conservative portfolios.
- Best for investors who want to measure performance based on loss-related volatility, not total market swings.
- Useful for comparing investments that show high upside volatility but limited downside movement.
How These Ratio Helps Investors Compare Portfolios
- Provide a standardised measure to compare different funds or portfolios with varying risk profiles.
- Highlight which portfolio offers better downside protection for each unit of return.
- Allow for smarter decision-making by identifying strategies that align with specific risk tolerances.
Practical Uses in Financial Planning
- Helps allocate funds toward steady, low-volatility investments.
- Assists advisors in evaluating portfolio stability during market downturns.
- Supports long-term planning by balancing returns with risk comfort levels.
How to Calculate the Sortino Ratio
The formula to calculate the Sortino ratio is:
Sortino Ratio = (Average Return тАУ Risk-Free Rate) ├╖ Downside Deviation
Where:
- Average Return is the mean return of the investment over a period.
- Risk-Free Rate is the return of a safe benchmark (e.g., government bond).
- Downside Deviation is the standard deviation of negative returns (returns below a target or minimum acceptable rate).
Applications of Sharpe and Sortino Ratios in Investment Decisions
Both the Sharpe Ratio and Sortino Ratio are important tools for comparing investments with different risk profiles. They help investors understand whether higher returns are justified by the amount or type of risk taken.
When to Use the Sharpe Ratio vs. the Sortino Ratio
- Use the Sharpe Ratio when assessing portfolios with balanced volatility, such as diversified mutual funds or ETFs.
- Use the Sortino Ratio when focusing on downside protection, such as in conservative portfolios or income-focused funds.
How These Ratios Help Investors Compare Portfolios
Both ratios standardise performance, allowing fair comparisons between different investments. A higher ratio (whether Sharpe or Sortino) indicates better risk-adjusted efficiency.
Limitations of Sharpe and Sortino Ratios
While the Sharpe and Sortino Ratios are among the most popular tools for measuring risk-adjusted returns, they come with certain limitations. These include:
Drawbacks of the Sharpe Ratio
- Assumes normal distribution of returns: The Sharpe Ratio assumes investment returns follow a normal bell curveтАФwhich often isnтАЩt true for real-world assetsтАФwhere returns can be skewed or have fat tails.
- Penalises all volatility equally: It treats upside and downside volatility equally, so positive returns can unfairly lower the score.
- Dependent on time period: The ratio can vary depending on the timeframe used (monthly, annual, etc.), potentially distorting comparisons.
Drawbacks of the Sortino Ratio
- Ignores upside volatility completely: While this is often its strength, it can understate total risk in highly volatile assets with extreme upward movements.
- Difficult to calculate downside deviation: Determining accurate downside deviation requires detailed data and a clear definition of тАЬminimum acceptable return.тАЭ
- Not standardised across platforms: Different analysts may use different MARs or timeframes, making cross-comparisons inconsistent.
FAQs
What is the Sharpe Ratio?
The Sharpe Ratio measures how much extra return an investment generates for every unit of total risk (volatility) taken. ItтАЩs used to evaluate the efficiency of returns relative to overall risk.
How do you calculate the Sharpe Ratio?
The Sharpe Ratio is calculated as:
(Average Return тАУ Risk-Free Rate) ├╖ Standard Deviation of Returns.
A higher value indicates better risk-adjusted performance.
What is the Sortino Ratio?
The Sortino Ratio measures returns relative to downside risk, focusing only on negative volatility (returns below a minimum acceptable rate). ItтАЩs a more refined version of the Sharpe Ratio for conservative investors.
WhatтАЩs the difference between Sharpe and Sortino ratios?
The Sharpe Ratio considers total volatility (both upside and downside). Similarly, the Sortino Ratio considers only downside volatilityтАФpenalising losses but not positive swings. In essence, Sortino gives a more accurate picture for risk-averse investors.
Which ratio should I use for my investments, Sharpe or Sortino?
Use the Sharpe Ratio if you want to compare portfolios or funds with balanced risk profiles. Similarly, use the Sortino Ratio if youтАЩre more concerned about downside protection and want to focus on loss management.
Disclaimer
The information provided in this article is for educational and informational purposes only. It should not be considered as financial or investment advice. Investing in stocks involves risk, and it is important to conduct your research and consult with a qualified financial advisor before making any investment decisions. The author and publisher are not responsible for any financial losses or gains that may result from the use of this information.
