The Sortino Ratio modifies the Sharpe Ratio by replacing total standard deviation with the standard deviation of returns below a minimum acceptable return (MAR) threshold, typically zero or the risk-free rate:
Sortino = (R − MAR) / σ_downside
where σ_downside is the root-mean-square of negative deviations from MAR (downside semi-deviation).
The rationale: investors are not penalized for upside volatility — large positive returns are desirable. Penalizing upside variance, as the Sharpe Ratio does, artificially deflates the performance measure for strategies with positive skewness.
When to prefer Sortino over Sharpe
- For strategies with significant positive skewness (trend following, options buying) where the Sharpe understates the risk-adjusted merit.
- When evaluating relative to a specific minimum acceptable return, such as a cash rate or inflation target.
Conversely, for short-volatility or option-selling strategies with negative skewness, the Sharpe may be artificially elevated while the Sortino is more revealing of the true risk profile, since it captures the frequent small gains that mask infrequent large losses.