How is the Sortino ratio calculated?

The Sortino ratio is a measure used to evaluate the risk-adjusted return of an investment or portfolio. It focuses on the downside risk, specifically the volatility of returns below a certain target or minimum acceptable return. The formula to calculate the Sortino ratio is as follows:

Sortino Ratio = (Average Return - Target Return) / Downside Deviation

To calculate the Sortino ratio, you need to follow these steps:

1. Determine the target return: This is the minimum acceptable return or the desired return that you want to achieve.

2. Calculate the average return: Find the average of the investment's returns over a specific period.

3. Calculate the downside deviation: Identify the returns that fall below the target return and calculate the standard deviation of these negative returns. This measures the volatility of the downside risk.

4. Subtract the target return from the average return: This gives you the excess return, which is the difference between the average return and the target return.

5. Divide the excess return by the downside deviation: This ratio provides a measure of the risk-adjusted return, specifically focusing on the downside risk.

The Sortino ratio helps investors assess the risk of an investment by considering the downside volatility and the potential for losses below a certain target return. A higher Sortino ratio indicates a better risk-adjusted return, as it suggests that the investment has generated higher returns relative to its downside risk.