In a previous blog, I wrote about the relationship between risk and reward, and how investors can analyze the returns an investment delivers in relation to the amount of risk it assumes.

As I noted, the Sharpe ratio is the best known tool for evaluating how much return an investment delivers per unit of risk. If two investments delivered the same level of returns, but one had a lot of variability in its returns along the way while the other’s returns remained fairly stable, the one with the more consistent returns would have a higher Sharpe ratio.

The problem with the Sharpe ratio, though, is that it penalizes upside and downside volatility equally. Volatility is a measure of risk, however, most investors don’t worry about volatility on the upside. When assets are rising in price, and more return often goes along with more risk, investors tend to focus on the return aspect of the risk/return balance. This focus changes in down markets. In declining markets where more volatility is associated with lower returns, investors tend to focus on the risk aspect of the risk/reward balance.

Loss Aversion

There is good reason for investors to be concerned about downside risk. From a mathematical standpoint, higher declines are more difficult to overcome. To use extreme numbers to illustrate the point, an investor who experiences a 50% decline needs to earn a 100% return to get back to whole, while an investor who experiences a 25% decline needs only a 33% gain to get back to the original value of their investment.

From an emotional standpoint, investors are very loss averse. Studies in behavioral finance by Nobel-prize winning economist Daniel Kahneman and others have shown that people experience the pain of loss to a much a greater degree than they do the satisfaction of gains. In an oft-cited example used to illustrate this point, in a coin flip wager most people would not accept losing $100 on tails even if they could win $150 if the coin came up heads.

The pain of losing $100 exceeds the satisfaction of winning 1.5 times that amount.

You could test yourself by asking how much you’d have to win to accept the prospect of losing $100. For most people, the answer is $200. In other words there is a 2:1 relationship between the experiences of losses vs. gains.

Basically, investors want more risk when the markets are going up and less risk when the markets are going down. The problem with the Sharpe ratio is that it treats risk in up markets and down markets the same way, when investors view the risk very differently and have a very different tolerance for the risk in up vs. down markets.

What if we could isolate the measurement to be just risk in down markets? This is exactly what the Sortino ratio does. It allows a comparison of the downside volatility of different funds with a single metric.

A Truer Measure of Risk

This tool – the Sortino ratio – addresses one of the limitations of the Sharpe ratio and looks at the returns that investments deliver only in relation to their volatility during down markets. To calculate the ratio, one would begin with an investment’s rate of return, then subtract the return of a risk-free investment, and then divide that sum by the standard deviation of the investment’s returns during down markets.

The standard deviation of returns measures the variability of returns, and by looking exclusively at how widely returns swing during down markets, the Sortino ratio focuses on the volatility that most concerns investors.

The Benefits of Cushioning Loss Aversion

Funds with high Sortino ratios hold up better in times of market stress. For example, funds in the Morningstar’s Conservative Allocation category that had high Sortino ratios declined 30% less than did the category, on average, during the great recession.1

Since people experience the pain of loss to such a high degree, during market downturns they are more likely to sell investments that have a lot of downside volatility than they are to sell investments that hold their value better under stress. Having some assets with lower downside risk in a portfolio allows investors to stay invested through volatile times and better adhere to a long-term financial plan, which is a win-win for the client and the advisor. Looking at the Sortino ratio is one way to identify funds that will fit this profile.

1Source: Morningstar Direct, 3/31/15. The “Great Recession” was measured using performance for the Conservative Allocation category from 10/10/07 – 3/9/09.