We all wish we could’ve owned shares of Apple or Amazon way back when those stocks went public decades ago. The thought of seeding just a few thousand dollars at the earliest stage of a growth stock’s life and then watching it compound to soaring heights is the lure of some investors. But there is a problem with that mindset: volatility.
Could you have stomached seeing 90% or more of your money get wiped out after the dot-com crash? Or what about 60%-plus drawdowns during the 2008 Great Financial Crisis? Indeed, riding out the ups and downs of even a diversified portfolio is no easy task. Fear often grips Wall Street and investors writ large, leading to inexperienced market participants and those without a plan to sell out at the very worst moment.
With that reality in mind, portfolio managers have two useful gauges of so-called “risk-adjusted returns.” What’s great is that these metrics are not obscure values that require a finance degree to understand. The Sharpe Ratio and Sortino Ratio are two of the most common measurements that help experts and casual investors alike determine how well a stock (or any investment) has performed over time compared to the level of risk taken. Let’s dive into these ratios so that you can understand why Allio prefers them in our portfolio assessments.
1. Sharpe Ratio
Between the two gauges of risk-adjusted returns, the Sharpe Ratio is more widely known. It was developed by William Sharpe and measures a portfolio’s return above the risk-free Treasury rate and then divides that difference by the portfolio’s standard deviation.
The higher the Sharpe Ratio, the better. A Sharpe above 0 means your portfolio’s return has been strong when compared to both what you could have earned taking no risk (in Treasury bills or cash) and how volatile your portfolio was over a given timeframe. The Sharpe Ratio is a comprehensive look at both upside and downside volatility, or the overall risk of a portfolio.
Sharpe Ratio = (Return - Risk-Free Rate) / Standard Deviation
Let's put some numbers to that. Suppose a stock returned 20% in a year while the risk-free Treasury bill rate was 5%. If the standard deviation of that stock was 40% (which is common for a single stock), then the Sharpe Ratio is calculated as:
Sharpe Ratio = (0.20 - 0.05) / 0.40 = 0.15 / 0.40 = 0.375
Therefore, the Sharpe ratio for the stock is 0.375. Not too bad. In general, a positive Sharpe ratio is what we’re looking for.
Now consider a low-risk play such as Procter & Gamble or Johnson & Johnson. We’ll say a 50/50 portfolio of those two blue chips returned 15% while the two-stock portfolio’s volatility was 8%. The risk-free rate remains at 5%. Here’s what that looks like.
Sharpe Ratio = (0.15 - 0.05) / 0.08 = 0.10 / 0.08 = 1.25
the Sharpe ratio for the portfolio is 1.25.
The higher Sharpe ratio indicates that the portfolio has a better risk-adjusted performance compared to the individual stock in the previous example. It suggests that the portfolio generated a higher return for each unit of risk taken, making it a more attractive investment option for risk-conscious investors.
The question really boils down to: Are you a risk taker or do you prefer a less volatile ride with your money? We find that most people would rather have less volatility, all else equal. Still, there are some dice-rollers out there that get their thrills from seeing wild net worth swings day by day – those are the exceptions to the norm.
2. Sortino Ratio
Let’s continue the Investment 101 crash course by dissecting the lesser-known Sortino Ratio. Developed by Frank Sortino, this risk-adjusted return valuation tool is considered the ‘Sharper’ Ratio. Here’s why: It only looks at downside risk.
After all, who cares if your portfolio is volatile if it only goes up, right? As portfolio managers, we’re all for that, but what’s concerning is when negative returns strike – like during bear markets. The Sortino ratio is calculated by subtracting the risk-free rate of return from the portfolio's average return and dividing it by the downside deviation (negative returns).
Sortino Ratio = (Return - Risk-Free Rate) / Downside Deviation
So, Sortino’s calculation only penalizes performance when it includes big losses. If you are of the risk-averse mindset, this ratio is probably what you want to look at when you review your portfolio’s performance. It’s particularly helpful to monitor the Sortino Ratio during tough times – like 2000, 2008, and 2022.
Taking our previous examples a step further, suppose the single-stock portfolio had a downside deviation of 30%:
Sortino Ratio = (0.20 - 0.05) / 0.30 = 0.15 / 0.30 = 0.5
In this instance, a Sortino Ratio of 0.5 says that the portfolio earned a higher return for each unit or downside risk compared to the risk-free rate. Since it is a positive value, performance was favorable while downside volatility was mitigated. Like the Sharpe Ratio, the higher the ratio the better.
For the P&G and J&J 50/50 portfolio, we’ll say there was a 5% downside deviation since those defensive companies tend to hold up well in downturns.
Sortino Ratio = (0.15 - 0.05) / 0.05 = 0.10 / 0.05 = 2.0
Again, the lower-returning portfolio sports a higher ratio than the single-stock risky portfolio.
Sharpe Ratio Versus Sortino Ratio Summary, Pros & Cons
(Return - Risk-Free Rate) / Standard Deviation
(Return - Risk-Free Rate) / Downside Deviation
Overall risk-adjusted return
Downside risk-adjusted return
Both upside and downside volatility
Only downside volatility (negative returns)
Measures risk-adjusted return for total risk
Measures risk-adjusted return for downside risk
Investments with both positive and negative returns
Investments with potential for significant downside risk
Higher ratio is generally preferred
Higher ratio indicates better downside risk management
Evaluating any investment type
Particularly useful during market downturns
Provides a measure of risk-adjusted return.
Focuses on downside risk, penalizing big losses.
Incorporates both upside and downside volatility.
Useful for risk-averse investors.
Widely recognized and used in the investment community.
Complements Sharpe Ratio by providing additional insight into downside risk.
Relies on historical data and may not accurately predict future returns or volatility.
Relies on historical data and may not capture all aspects of risk.
Assumes a normal distribution of returns, which is rarely the case.
Assumes a normal distribution of returns, which is rarely the case.
Does not differentiate between macro and firm-specific risk.
May not be suitable for all investment strategies, particularly those with a higher tolerance for volatility.
Why These Ratios Matter at Allio
The Sharpe and Sortino Ratios compare performance to volatility. They are like ‘signal-to-noise' comparisons and convey how smooth or bumpy your portfolio’s ride was over a period. Just displaying an investment’s return doesn’t tell us what it felt like on the way to achieving that performance.
Was it akin to being on an easy-going Ferris wheel (such as in a low-risk bond fund)? Or did it feel as if you were on a scary roller coaster (like in a concentrated allocation of a few volatile stocks)? Or somewhere in between? The Sharpe and Sortino Ratios give a sense of what the journey was like.
While the numbers matter, these two ratios are just as much about you as they are about the portfolio. Risk-averse investors may want to pay closer attention to the Sortino Ratio while people who don’t care a whit about volatility might prefer to disregard both metrics. At Allio, we are risk-aware managers. We believe that smoothing out returns helps investors stay in the game to achieve long-term wealth and financial freedom.
The Bottom Line
Both the Sharpe and Sortino ratios are useful risk-adjusted return metrics that offer insights into a portfolio’s performance relative to risk. While the Sharpe Ratio uses the broader standard deviation risk gauge, the Sortino Ratio focuses on just downside volatility. Both ratios put an allocation’s performance in a proper risk context. Ultimately, both measures help each investor make better decisions based on their unique risk tolerance levels.