Sortino Ratio
Return per unit of downside volatility; penalizes only bad volatility in backtesting.
Definition
Sortino ratio = (R − R_f) / σ_downside, where σ_downside is the standard deviation of returns below a target (often zero or the risk-free rate). It uses only “bad” volatility instead of total volatility.
Why it matters for backtesting
- Downside focus: Many investors care more about losses than overall variability.
- Asymmetric payoff: Strategies with positive skew (e.g. options selling) can have a better Sortino than Sharpe.
- Target-relative: Can use a minimum acceptable return (MAR) as the target instead of zero.
Limitations
- Definition of “downside” (target, threshold) is arbitrary.
- Less standard than Sharpe; harder to compare across studies.
- Still a single number; does not describe tail shape.
Linked concepts
Sharpe ratio, volatility, max drawdown, Calmar ratio.