The Sortino Ratio is a modified version of the Sharpe ratio. It is used by investment managers to calculate portfolio risk. The Sharpe ratio quantifies the return (alpha) over the volatility (beta) assumed in the portfolio. However, the Sortino Ratio only includes downside risk which is measured as a deviation (downside deviation) from the norm or minimum acceptable return (MAR).
Review the formula. The Sortino Ratio = (Compound Period Return - MAR) / Downside Risk.
Calculate Compounded Period Return. The compound period return = (1+Total return)^(1/N) - 1. Where N is the number of periods and total return is the return over a certain time period. A 10% return over 5 years would yield a compounded period return of 1.5^(1/5) - 1. A compounded 'monthly' return would change the number of periods from 5 to 60.
Calculate the minimum average return (MAR). This is up to the investor. It can be 0 percent or the current risk free rate divided by 12. 10 year treasuries can be used as a proxy for the risk free rate.
Calculate downside deviation. If you are familiar with quantitative methods and statistics, this is computed like a standard deviation, however, it ignores all positive results. The equation can be calculated in MS Excel.
Start by subtracting MAR from each period's return. You only want the negative values, so if the number is positive, adjust to 0.
Square the period returns and sum all for a total.
Divide the sum by the total number of periods and then take the square root of this number. This is the Sortino Ratio. Again, this is equivalent to a standard deviation equation with no positive return results.