The Sortino ratio measures the risk-adjusted return of an investment asset, portfolio, or strategy.
The Sortino ratio is used as a way to compare the risk-adjusted performance of programs with differing risk and return profiles.
An intuitive way to view downside risk is the annualized standard deviation of returns below the target.
The squaring of the below-target returns has the effect of penalizing failures at a quadratic rate.
Using the observed points to create a distribution is a staple of conventional performance measurement.
Our ability to make these statements comes from the process of assuming the continuous form of the normal distribution and certain of its well-known properties.
As a caveat, some practitioners have fallen into the habit of using discrete periodic returns to compute downside risk.
This method is conceptually and operationally incorrect and negates the foundational statistic of post-modern portfolio theory as developed by Brian M. Rom and Frank A. Sortino.
The Sortino ratio is used to score a portfolio's risk-adjusted returns relative to an investment target using downside risk.
This is analogous to the Sharpe ratio, which scores risk-adjusted returns relative to the risk-free rate using standard deviation.
As skewness increases and targets vary from the median, results can be expected to show dramatic differences.