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Sortino Ratio: Required Return vs Risk-Free Return
Correct Answer
The Sortino ratio uses the required (target) return, not the risk-free return.
Why Required Return Is Used
The purpose of the Sortino ratio is to focus only on downside risk — returns that fall below an investor’s minimum acceptable return. That minimum acceptable return is called the required return (or target return).
Using the risk-free rate would not accurately reflect an investor’s true performance goal.
Sortino Ratio Formula (Simple)
Sortino Ratio = (Portfolio Return − Required Return) ÷ Downside Deviation
Simple Example
- Portfolio return = 10%
- Required (target) return = 6%
- Downside deviation = 4%
Sortino ratio = (10% − 6%) ÷ 4% = 1
This means the portfolio earned 1 unit of return for every unit of downside risk taken.
Comparison With Sharpe Ratio
- Sharpe ratio uses the risk-free return and total volatility
- Sortino ratio uses the required return and downside volatility only
Why This Matters
Investors are usually not worried about returns being too high — they are worried about returns being too low. The Sortino ratio captures this concern more realistically.
Key Point to Remember
Sharpe ratio → risk-free return
Sortino ratio → required (target) return
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