The Sortino ratio, developed by Frank A. Sortino, is a variation of the Sharpe ratio that differentiates between harmful volatility and total volatility. While the Sharpe ratio uses total standard deviation as its risk measure, the Sortino ratio uses only downside deviation, which captures the volatility of returns that fall below a specified target or minimum acceptable return (MAR). The formula is: Sortino Ratio = (Rp - MAR) / Downside Deviation, where Rp is the portfolio return.

This distinction is important because investors generally do not mind upside volatility. If a portfolio occasionally produces returns far above the average, that should not be penalized as "risk." The Sortino ratio addresses this asymmetry by focusing exclusively on the downside. A Sortino ratio above 2.0 is typically considered good, while values above 3.0 suggest excellent downside risk management.

For example, a portfolio returning 12% with a target return of 5% and a downside deviation of 8% has a Sortino ratio of 0.875. This means the investor earns about 0.875 units of excess return per unit of downside risk. The Sortino ratio is especially useful for evaluating strategies that have asymmetric return distributions, such as options-based or momentum strategies where upside and downside volatility differ significantly.