Downside Deviation CFA® Exam Study Notes

Consider Invesco India Contra that has a downside capture of 98% (based on 1-month losses). On the upside, though, it captures 112% of the Nifty 500’s gains, resulting in better-than-average returns. The Sortino ratio is computed by dividing the difference between the aggregated earnings of an investment portfolio and the risk-free rate of return https://1investing.in/ with the standard deviation of negative earnings. There are a few factors that can significantly affect a portfolio’s Sortino Ratio, giving you a false result. One of them is the timeframe used in analyzing the portfolio returns. The period for consideration must be multiple years and in fact, it should cover a complete business cycle.

  • Very well explained and gives a great insight about topics in a very short time.
  • The Sharpe ratio may be recalculated on the finish of the 12 months to look at the actual return somewhat than the anticipated return.
  • When the Sortino Ratio is very low or negative, it means that the investment does not get rewarded for taking on additional risk.
  • The Sharpe ratio was developed by Nobel laureate William F. Sharpe and is used to help traders perceive the return of an investment in comparison with its danger.

For example, ICICI Pru Savings Fund’s average 1-year return over the past 4 years has been 8.05%, better than ABSL Money Manager’s 7.8%. But the ICICI fund saw 1-week returns slip into losses 7% of the time against the ABSL fund’s 1.3%. Standard deviation also does not tell you whether the deviation was higher on the upside or downside. Therefore, use this metric to understand volatility, but combine it with metrics explained further down to get the full picture. A standard deviation number on its own won’t tell you anything – it should be compared with other funds. Quant Active Fund, for example, has a 1-year standard deviation in return over the past 4 years at 34%.

This article provides an Excel spreadsheet to calculate downside deviation . It also discusses why downside deviation is a better risk measure than the standard deviation. Notably, both ratios are a risk-adjusted measure of returns on investment. Regardless, there are a few essential points of differences that set them apart.

Performance Of All 75 Candlesticks – (BACKTESTED)

To perform the calculation, we will need to collect the following values; the return, the risk-free rate and the downside deviation. A beta of more than 1 means that which ratio uses downside deviation the fund can gain more on uptrends and fall more in corrections. Alpha measures the excess returns a fund generates given its beta and what the market delivers.

which ratio uses downside deviation

Both these ratios help investors check how a portfolio or asset is likely to perform despite the market fluctuations. As a result, they focus on the volatility and derive respective results, be it assessing the risk or additional returns. However, I think that the downside deviation is not calculated correctly. For instance, if you have 5 returns and 3 meet you requirements, then the array formula will use 3 in the denominator, rather than 5 (or 5-1, for sample data).

Sortino ratio

The Sortino ratio is calculated by taking the actual return, subtracting the risk-free rate of return, and dividing that number by the standard deviation of negative asset returns. The Sortino Ratio is a variation of the Sharpe Ratio, and the difference between the two is that the Sortino Ratio removes the effects of upward price movements to focus on the distribution of the negative returns. Downside deviation does not convey any information about upside potential, so it provides an incomplete picture. In fact, it is guaranteed to outperform, the only question is by how much. Downside deviation, similar to semi deviation, eliminates positive returns when calculating risk. Instead of using the mean return or zero, it uses the Minimum Acceptable Return as proposed by Sharpe .

which ratio uses downside deviation

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But the former’s Sharpe is far better at 2.54 against the L&T fund’s 1.46 because it was half as volatile. On the other hand, while UTI Flexicap is higher volatile than, say, DSP Flexicap , it still scores better on Sharpe as its returns have been high enough to make up for that higher volatility. Volatility helps you understand the extent to which returns can swing and what to expect from the fund based on how the market is performing. Although the risk-free rate of return is generally used, the expected return can also be used for these calculations.

Company

A portfolio can seem to have a low-risk score simply because the underlying securities in the portfolio are illiquid. For example, small-cap stocks or investments in privately held companies, which are not frequently priced, tend not to fluctuate that much. You can compare the Sortino Ratio for different portfolios to find out which delivered the greatest downside risk-adjusted return over a given period since the ratio measures excess return per unit of downside risk. In finance, the Sortino Ratio has been found very useful in many ways, but here, we will only consider a few examples.

The total of the squares of these three instances is -12%, and when we divide by the total of 10 periods, we come up with -1.2%. The square root of 1.2 is about 1.1, for a downside deviation of about 1.1%. A stock with a high downside deviation can be considered less valuable than one with a normal deviation, even if their average returns over time are identical. That’s because when a stock dips, it will require higher returns in the future to get back to where it was. In this case, A would have 0.8 added to all the values and B would have 0.9 subtracted from all of them.

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Sortino Ratio overview

This ratio tends to address the shortcomings of standard deviation as a measure of potential risks in a return and risk trade-off ratio. Retail investors often struggle to select the ‘right’ investment scheme that matches their financial requirement and investing capability. However, with the help of financial ratios like the Sortino ratio, they can evaluate a scheme’s performance in a much better manner. The Sortino ratio only measures downside deviation while the Sharpe ratio measures both upside and downside deviation. The Sortino ratio is a measurement of an investment asset or portfolio’s risk-adjusted return. For example, because this ratio is only focused on downside deviation, all limitations of the risk automatically apply to the calculation.

Sortino ratio – What is a good number? (What is it and how do you use it?)

What sets the Sortino ratio apart is that it acknowledges the difference between upside and downward risks. More specifically, it provides an accurate rate of return, given the likelihood of downside risk, while the Sharpe ratio treats both upside and downside risks equally. It helps to represent a realistic idea about the downside risks that accompany a stock or a fund.

The articles and research support materials available on this site are educational and are not intended to be investment or tax advice. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. As skewness increases and targets vary from the median, results could be anticipated to point out dramatic differences. The return of the fund is the return that your fund manager earns in absolute terms. The threat-free return is what you would have earned with none threat as in case of a bank FD. Upside volatility is a plus; therefore, it should not be included in the risk calculation, as is the case with the Sortino Ratio.

Another difference is that the main formula of the Sortino Ratio uses the target/required return, instead of the risk-free rate of return, in the numerator of the formula. However, some people still use the risk-free rate of return to simplify the formula. While DD has some advantages, there are also disadvantages when using this measure. The first disadvantage is that in a lot of cases, standard deviation will yield similar results as downside deviation. The advantage of using the standard deviation, however, is that standard deviation is more well-behaved as a measure, whereas downside deviation can sometimes be hard to work with.

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