The Sortino Ratio improves on the Sharpe Ratio by differentiating between harmful volatility (downside) and beneficial volatility (upside). While the Sharpe Ratio penalises all volatility equally, the Sortino Ratio only considers negative deviations.
Formula
Sortino Ratio = (Rp - Rf) / σd
Where σd is the standard deviation of negative returns only (downside deviation).
When to Use Sortino vs Sharpe
- Use Sharpe for broadly symmetric return distributions
- Use Sortino when your strategy has positive skew (large up moves, small down moves) — common in momentum and trend-following strategies
- A strategy with Sharpe 1.0 but Sortino 1.5 has relatively mild downside risk compared to its total volatility