The Sortino ratio measures risk-adjusted returns by focusing only on downside volatility rather than total volatility, dividing excess return by downside deviation below a target return. This ratio provides a more accurate risk assessment than the Sharpe ratio for strategies with asymmetric return distributions or upside volatility that doesn’t represent risk.

Sortino ratio analysis better captures the risk characteristics of trading strategies that experience positive volatility during favorable periods but seek to minimize downside risk. This measure is particularly useful for evaluating hedge funds and alternative investment strategies with non-normal return distributions.

Real-world example: A hedge fund with 12% annual returns and 8% downside deviation below 5% target achieves a Sortino ratio of 0.875 (12%-5%)/8%, providing better risk assessment than Sharpe ratio for strategies with upward volatility spikes.