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Sharpe and Sortino: return you can compare

A raw return means nothing until you know the risk taken to earn it. How the Sharpe ratio prices return per unit of volatility, why the Sortino ratio fixes its biggest flaw, and what counts as good.

Technical AnalysisAdvanced10 min read

Written by Onam SharmaLast reviewed Report a correction

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Two traders both returned 18% last year. One did it with steady, boring gains; the other lurched between +40% and −25% along the way. Reported as a single number, their years look identical — and that is the trap the Sharpe ratio exists to escape. A return is only half a result; the risk taken to earn it is the other half, and risk-adjusted metrics are how professionals compare the two fairly.

The Sharpe ratio: return per unit of volatility

The Sharpe ratio asks a simple question: how much return did you earn above the risk-free rate, for each unit of volatility you accepted? You subtract the risk-free rate (what a government bond or T-bill pays for zero risk) from your return, then divide by the standard deviation of your returns. A higher ratio means you were paid more for the turbulence you sat through. It turns "I made 18%" into "I made 18%, and here is how bumpy the ride was" — a claim you can actually compare with someone else’s.

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Feed in a return, the risk-free rate, and the volatility, and watch the Sharpe ratio — then add a downside deviation and see how the Sortino ratio rewards a strategy whose swings are mostly upward.

Worked example
Two 18% years, two very different Sharpe ratios
Risk-free rate 6%
Trader A returnVolatility 8%18%
Trader A SharpeWell paid for the risk(18 − 6) ÷ 8 = 1.5
Trader B returnVolatility 30%18%
Trader B SharpePoorly paid for the risk(18 − 6) ÷ 30 = 0.4
Same headlineA took far less risk for itVery different quality
The identical 18% return earns a Sharpe of 1.5 for Trader A and 0.4 for Trader B. A took a much smoother path to the same place, and the Sharpe ratio makes that difference visible where the raw return hides it. When someone quotes only a return, they are quoting the numerator and hiding the denominator.

The Sortino ratio: only downside counts as risk

The Sharpe ratio has a real flaw: it treats upside volatility as risk. A strategy that occasionally jumps +30% is punished by the same standard deviation that punishes −30% drops, even though nobody complains about the good surprises. The Sortino ratio fixes this by replacing total volatility with downside deviation — the volatility of returns below a target (often zero or the risk-free rate). It measures return per unit of harmful risk only, and for a strategy whose swings are mostly upward it gives a fairer, usually higher, reading.

Check yourself

Strategy X returned 25% with a Sharpe of 0.5; Strategy Y returned 14% with a Sharpe of 1.8. Which is the higher-quality result, and why?

Simple bhasha mein
Return achha ya sirf jhoola?

Do log dono ne 18% kamaya. Ek ne aaram se, doosre ne +40%/−25% ke jhoole mein. Return same, par quality alag. Sharpe ratio yahi batata hai — kitna return, kitne risk (volatility) pe. (18−6)÷8 = 1.5 achha; (18−6)÷30 = 0.4 kharaab. Sortino aur bhi fair — sirf neeche wali (harmful) volatility ginta hai, upar wale achhe jhatke ko saza nahi deta. Koi sirf return bataye toh aadhi kahani chhupa raha hai — ratio poochho.

What to remember
  • A raw return is meaningless without the risk taken to earn it.
  • The Sharpe ratio is excess return divided by total volatility — return per unit of risk.
  • Rough bands: under 1 is weak, around 1 acceptable, over 2 very good, over 3 excellent.
  • The Sortino ratio uses only downside deviation, so it does not penalise upside swings.
  • Both are easily flattered by a short window, a low risk-free rate, or ignoring costs.
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Common questions

Short, direct answers to what people ask about this topic.

what is the sharpe ratio
The Sharpe ratio measures how much return a strategy or portfolio earned for each unit of risk it took, where risk is measured as volatility. It is calculated as the return above the risk-free rate divided by the standard deviation of returns, so a higher number means you were paid more for the ups and downs you endured. Its purpose is to make two returns comparable: a 20% return earned smoothly is far better than a 20% return earned through wild swings, and the Sharpe ratio is what lets you say so with a single figure rather than a gut feeling.
what is a good sharpe ratio
As a rough guide, a Sharpe ratio below 1 is considered poor to mediocre, around 1 is acceptable, above 2 is very good, and above 3 is excellent and rare over long periods. Those bands assume the ratio is computed over a meaningful stretch with a sensible risk-free rate; a dazzling Sharpe measured over a few lucky months means little. Context matters too — an equity strategy and a bond strategy live in different volatility worlds — but for comparing like with like, higher is better and anything sustained above 2 is genuinely strong.
what is the difference between the sharpe and sortino ratio
Both divide excess return by a measure of risk, but they define risk differently. The Sharpe ratio uses total volatility — it treats upside swings as risk just as much as downside ones, which unfairly penalises a strategy for its good surprises. The Sortino ratio fixes this by using only downside deviation, the volatility of returns below a target, so it measures return per unit of harmful risk alone. For a strategy with lumpy but mostly upward returns, the Sortino ratio usually gives a fairer, higher reading than the Sharpe.
how do you calculate the sharpe ratio
You take the portfolio’s return, subtract the risk-free rate to get the excess return, and divide that by the standard deviation of the portfolio’s returns. For example, a 15% return with a 6% risk-free rate and 12% volatility gives (15 − 6) ÷ 12 = 0.75. To annualise a Sharpe computed from monthly returns you multiply by the square root of 12. The key judgement calls are the period you measure over and the risk-free rate you subtract, both of which can flatter or flatter the result if chosen carelessly.