Sortino Ratio
Categories: Financial Theory
There’s a lot that goes into portfolio management: numbers, accounting, crystal balls. But one of the most important elements revolves around how you manage volatility.
Usually, investors choose to trade off volatility for risk...but what if you could separate out general volatility from the harmful volatility (i.e. losses)? That’s what the Sortino ratio does. It's a risk-adjusted measure of portfolio returns with a certain financial goal in mind.
The higher your Sortino ratio, the better your portfolio is performing. It all depends on what you set as the lowest acceptable returns on your investments though...so the more realistic you’re being, the better.
If you’ve heard of the Sharpe ratio, the Sortino ratio is very similar. The Sharpe ratio adjusts for upward and downward volatility, while the Sortino ratio only adjusts for downward volatility. While the Sharpe ratio is symmetric, a lot of portfolio managers prefer the Sortino ratio, since they only want to negate losses. Upward volatility is a good thing...where the money’s at (when you've bet that way in your investments).
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Finance: What is the Sharpe Ratio?6 Views
finance a la shmoop what is the Sharpe ratio well it's a calculation used by
investors in trying to figure out whether their investment was smart or [Sharpe ratio definition on 100 dollar bill]
just lucky or rather it's a measure to measure the amount of risk they took in [Smart and lucky on either side of balance scale]
order to get a given level of reward and remember risk and reward are joined at
the wrist like handcuffed politicians fighting for that one congressional seat [Politicians fighting over a chair]
in Alaska all right well for example if you spent five bucks on a lottery ticket
and won a million yes the outcome was mathematically good and yes you made 200
thousand times your money but was that a high Sharpe ratio investment no why
because your odds of winning were in fact one in a billion so you were just [Lottery billboard appears]
lucky like extremely lucky not necessarily good on the other hand what
if you had taken a deep dive and looked hard at Amazon in 1998 when it was [Woman with Amazon paper in library]
valued at a tiny fraction of where it's valued today well you could have done
the math on its profit margins which were nearly zero or negative for a very [Person using calculator]
long time you could have thought about how the public markets would perceive a
company growing revenues massively at such a level that in a decade they'd end [Amazon watering can sprinkles over revenues]
up beginning to destroy Walmart you could have looked at the amazing ease
with which product are delivered to lazy homeowners who love not having to get up [Man in frog onesie sitting on couch]
off their fat Duff's and drive to the store and park fighting crowds and angry
union cashiers who are upset to be bothered in the checkout line have you
done all this research and concluded that Amazon would go from a hundred [Amazon revenues graph rises]
million dollars in book sales to hundreds of billions of dollars of sales
of pretty much everything two decades later well then you would have done
high-quality research made a return analogous to your lottery ticket
winnings and maybe not two hundred thousand times but something close but
would have produced a very high Sharpe ratio because the quality of the
research and the risk management along the way was extremely high you also
could have gleaned that Amazon's growth when it was small was the envy of every [BestBuy and Oracle appear and look at amazon chart]
big-box retailer you know like Best Buy every technology firm like
Oracle and all the other establishment companies of the world from banks to
even oil companies probably certainly insurance companies such that for a
price amazon always would have been a relatively easy sale to one of those [Man taping up a box]
guys so that the downside on the investment all along the way was likely
a pretty limited so the bottom line high Sharpe ratios good research good smart
analysis good lottery tickets hugely bad very very bad
although investing in a company called chloroform energy drinks would probably [Man holds bottle of chloroform]
be even worse