The Sharpe Ratio. Now, the Sharpe Ratio was first devised in the mid-1960s by Stanford Finance Professor, William Sharpe. as a measure to compare the performance of mutual funds. And it's a measurement of the manager's returns excess of the risk-free rate while factoring in the risk taken on by the manager. You'll also potentially hear it called the reward to variability ratio. And the Sharpe Ratio, to this day, is probably the most widely-used and followed risk-adjusted measure for investment funds. Now, digging in deeper into how it's calculated, again, it compares the excess return to the total risk measured by the standard deviations of returns of the portfolio. The standard deviation of returns is also known as volatility. Now, this allows investors to compare investments on a risk-adjusted basis and not just on returns. So it allows us to compare the performance of various funds, even if they do not have the same risk profile. Now here is your Sharpe Ratio formula. And it's the excess returns, again, that's calculated by the return on the portfolio minus the risk-free rate divided by their standard deviation of returns. And as you may have guessed, the higher the Sharpe Ratio, the more favorable of an investment return relative to the risk being taken. So looking at it from another angle, if two funds offer similar returns, but the one has a higher standard deviation, that fund will have a lower Sharpe Ratio. And that lower Sharpe Ratio indicates less return for every unit of risk taken on by the portfolio manager. Now, early in the 1980s, Dr. Frank Sortino had undertaken some research in an effort to improve how we measure risk-adjusted returns, and more specifically, the Sharpe Ratio. And he devised a very similar ratio called the Sortino Ratio. And here, we're measuring the excess return provided by the portfolio manager per level of downside risk. Now, unlike the Sharpe Ratio, it does not include upside volatility in its calculation. And by doing that, it addresses one of the major criticisms or shortcomings of a Sharpe Ratio, because a Sharpe Ratio uses a standard deviation measure of risk that includes both good risk, upside volatility, and bad risk. So for a Sortino Ratio, which is simply comparing the return to Downside Deviation, because after all, investors are most concerned with downside movements in their portfolio. Now here is the Sortino Ratio formula, very similar to the Sharpe Ratio. The numerator is exactly the same. Excess returns is the return of the portfolio minus the risk-free rate. But instead of standard deviation of returns, we're just using Downside Deviation. And it's interpreted the same way. The higher the ratio, the more favorable of an investment return, compared to its relative downside risk.
