The Sortino ratio

The Sharpe ratio treats all volatility as bad. But investors do not lose sleep over unexpectedly large gains — only over losses. The Sortino ratio fixes this by measuring only downside risk.

The adjustment

It is built like the Sharpe ratio, but the denominator changes:

Sortino ratio = (portfolio return minus target return) / downside deviation

Downside deviation is the standard deviation computed using only returns that fell below a target (often the risk-free rate or zero). Upside swings are excluded from the risk measure entirely.

Why it can change the verdict

Consider two strategies with identical Sharpe ratios. One is volatile mostly because it occasionally jumps up; the other is volatile because it occasionally crashes. The Sharpe ratio rates them equally. The Sortino ratio rewards the first and punishes the second, matching how an investor actually experiences them.

A quick example

Target return = 0 percent
A strategy's negative-return months produce a downside deviation of 8 percent
Average return above target = 7 percent
Sortino = 7 / 8 = 0.875

When to lean on it

Sortino is most informative for strategies with asymmetric return profiles — option selling, trend following, anything that does not look like a symmetric bell curve. For roughly symmetric portfolios it tells nearly the same story as Sharpe. Its weakness is statistical: by using only downside months you have fewer data points, so the estimate is noisier and less stable than Sharpe.