When evaluating trading strategies or portfolio performance, two of the most popular risk-adjusted return metrics are the Sharpe Ratio and the Sortino Ratio. While both metrics aim to provide insights into how effectively a strategy generates returns relative to risk, they focus on different aspects of volatility.
Understanding the strengths and weaknesses of each metric is critical for retail traders and investors aiming to make informed decisions.
What Is the Sharpe Ratio?
The Sharpe Ratio evaluates the return of an investment relative to its overall risk (as measured by total volatility). The formula is:
- Strengths:
- Simple and widely used.
- Accounts for all volatility, both upside and downside.
- Useful for comparing strategies with similar characteristics.
- Limitations:
- Penalizes upside volatility, even though it benefits the investor.
- Can overstate risk in highly volatile but profitable strategies.
What Is the Sortino Ratio?
The Sortino Ratio refines the Sharpe Ratio by isolating downside volatility (risk) rather than considering all volatility. Its formula is:
- Strengths:
- Focuses only on downside risk, which is more relevant to most investors.
- Ideal for strategies that exhibit high upside volatility (e.g., trend-following strategies).
- Limitations:
- Requires defining a threshold (e.g., risk-free rate or zero return) for downside risk.
- Less commonly used, so benchmarking against peers may be difficult.
When to Use Each Metric?
- Sharpe Ratio:
- Best for balanced strategies with symmetrical return distributions.
- Useful for evaluating strategies with consistent risk-return profiles.
- Sortino Ratio:
- Better for strategies with skewed returns, such as momentum or trend-following systems.
- Ideal when upside volatility should not be penalized (e.g., aggressive growth strategies).
