Introduction:
Investors who understand risk are of fundamental importance in the Forex market, as risks are major components of any trading strategy. Measuring the risks is even more important and a single measure can provide insight on how risky the trading strategy is supposed to be. The Sortino Ratio is a way to calculate risk-adjusted return of a portfolio and help investors measure the downside deviation in the market. In this article, we will discuss how to calculate the Sortino Ratio with practical examples, and use it to evaluate and optimize Forex investment strategies.
What is Sortino Ratio?
The Sortino Ratio is a tool used to quantify the risk-adjusted performance of investment or trading strategies. It was developed in the 1990s by Frank Sortino and Stephen Satchell, the idea being to measure the downside deviation relative to the performance of the investment. As such, the Sortino Ratio helps to determine how much risk an investor is taking by investing in the market compared to its return.
In simple terms, the Sortino Ratio is a measure of one’s risk-adjusted returns on a portfolio, or how well the portfolio performs against a predetermined standard of risk. By looking at the Expected Return and Downside Deviation only, investors can use the Sortino Ratio to better understand their portfolio and make more informed decisions about future investments.
How to Calculate the Sortino Ratio?
The Sortino Ratio is calculated using the following formula:
Sortino Ratio = (Expected Return – Risk Free Rate) / Downside Deviation
The Sortino Ratio measures the performance of the investment when compared to the expected return which is based on the optimal risk-reward threshold. It also accounts for the downside risk associated with particular investment or trading strategy. The higher the value, the more effective the portfolio is at producing returns relative to the amount of risk taken.
The ‘Expected Return’ is the expected return from the investment over a given period. The ‘Risk Free Rate’ is the return from the risk free asset such as Cash, public debt etc. The ‘Downside Deviation’ is the measure of the variation in returns when losses are considered.
Expected Return:
The Expected Return is determined using the following formula:
Expected Return = {Sigma (Return × Chance of Occurrence)}
The Expected Return is the expected return from the portfolio over a given period. It takes into account the chance of occurrence for each return from the portfolio.
Risk Free Rate:
The Risk Free Rate is the return from an asset such as Cash or government Bonds which have no expected risk of default.
Downside Deviation (Semi-Variance):
The Downside Deviation is the measure of the variation in returns when losses are considered. It is calculated using the following formula:
Downside Deviation = {Sigma (Losses × Chance of Occurrence)}
Where ‘Losses’ is the negative return from the portfolio and ‘Chance of Occurrence’ is the probability of that return occurring.
Practical Examples
An example of calculating the Sortino Ratio is given below. Assume that we have a portfolio which is expected to generate a return of 10% with 40% chance, return of 12% with 60% chance, -5% with 5% chance, -3% with 10% chance, and -1% with 25% chance. The Risk Free Rate is assumed to be 4%.
Expected Return = 10%×40% + 12%×60% – 5%×5% – 3%×10% – 1%×25%
= 7.2%
Downside Deviation= -5%×5% – 3%×10% – 1%×25%
= -1.9%
Sortino Ratio = (7.2% – 4%)/-1.9%
= 2.9
In this example, the Sortino Ratio of the portfolio is 2.9 which indicates that the portfolio is performing well relative to the amount of risk taken.
Benefits and Limitations of Sortino Ratio
The Sortino Ratio has several benefits over traditional measures of risk. Firstly, it enables investors to measure the downside risk associated with an investment which traditional measures such as the Sharpe Ratio does not take into account. Secondly, the Sortino Ratio can be used to compare the performance of different portfolios or investments. By looking at the Sortino Ratio of a particular trading strategy, investors can easily determine whether the portfolio is performing better than expected relative to the amount of risk taken.
The main limitation of the Sortino Ratio is that it does not take into account the potential rewards of the investment. As such, investors must also consider the expected returns when evaluating the portfolio using the Sortino Ratio.
Conclusion
The Sortino Ratio is a useful tool for measuring the risk-adjusted performance of a portfolio or investment. It enables investors to compare portfolios against one another and make more informed decisions about future investments. Additionally, the downside risk associated with an investment can be easily identified using the Sortino Ratio. However, it is important to keep in mind that the Sortino Ratio does not take into account the potential rewards from an investment, and that should also be taken into consideration.
Overview of Sortino Ratio
The Sortino Ratio is a measure of an asset or portfolio’s return that takes into consideration the risk that is associated with the asset or portfolio. It subtracts the risk-free rate from an asset or portfolio’s return and then divides the amount by the asset’s downside deviation. This measure can be used to compare different types of investments and measure their risk relative to their potential return. A higher Sortino Ratio indicates that an asset or portfolio has a higher potential return relative to its risk.
The Sortino Ratio’s formula is calculated as follows: Sortino Ratio = (Portfolio Return – Target Return) / Downside Risk. This formula takes into account the downside risk of each investment to arrive at a score that can then be used to help with making an investment decision. The higher the Sortino Ratio, the higher the potential return for a given amount of risk.
Advantages and Disadvantages of the Sortino Ratio
The Sortino Ratio is a useful tool for investors looking to compare different types of investments and make the most of their portfolio’s returns. It takes into account the risk associated with each investment and provides a score that can be used to help with making an investment decision. This makes the Sortino Ratio a valuable tool when it comes to investing.
However, the Sortino Ratio does have some drawbacks. This ratio only considers downside risk and does not take into account the upside potential of an asset or portfolio. In addition, the Sortino Ratio does not different between types of risk i.e. liquidity risk, credit risk, or volatility risk. Therefore, it is important to consider other factors when making investment decisions.
Conclusion
The Sortino Ratio is a useful tool for investors when it comes to making investment decisions. It gives investors the ability to measure the return of an asset or portfolio relative to its risk. By taking into account the downside risk of an investment, the Sortino Ratio helps investors make informed decisions and potentially maximize returns on their portfolio.
Despite this, it is important to consider other factors when making investment decisions. The Sortino Ratio only considers downside risk and does not differentiate between types of risk. Therefore, it is important to factor in other information and research before making any investment decisions.
