GLOSSARY // Risk & Psychology
Sortino Ratio
The Sortino ratio is the Sharpe ratio with one change: the denominator counts only downside volatility, so returns above the target do not count against the strategy. The formula is (portfolio return - risk-free rate) / downside deviation, where downside deviation penalizes only the below-target returns — above-target periods enter the calculation as zeros, not as risk.
The change fixes Sharpe's most-criticized flaw. A strategy that grinds small gains and occasionally spikes 15% in a month gets punished by Sharpe for those spikes; Sortino ignores them and prices only the pain. For strategies with asymmetric return profiles — trend following, momentum, anything with a long options component — the two ratios can rank the same track records in opposite order.
Because downside deviation is driven by only the losing periods, it is noisier than full volatility, and a short track record with few losing periods can produce absurdly high Sortino readings. A strategy that simply has not been tested by a bad regime yet is not the same as a strategy with controlled downside.
A portfolio returns 12% against a 4% risk-free rate. Its full standard deviation is 16%, but its downside deviation is 10%. Sharpe = (12 - 4) / 16 = 0.5; Sortino = (12 - 4) / 10 = 0.8. The gap tells you a meaningful chunk of the volatility was upside — the kind nobody complains about.
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Educational only — not financial advice. Definitions simplified for clarity; markets are messier than definitions.