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Daily Traders Edge

Some Lessons From The Recent Market Volatility

February 13
09:52 2018

Everybody knows the markets are more volatile now than they were just a few weeks ago. But exactly how volatile are they know, and how calm were they previously? Can we use numbers to describe those things?

What is the Sortino Ratio?

It turns out we can. In finance there’s a metric called the Sortino Ratio. It measures return relative to downside volatility (a variation of standard deviation). A higher number is better than a lower number, but the number can get higher in a few different ways – returns can go up, downside volatility can go down, or both returns can go up and volatility can go down simultaneously. Higher returns by themselves are not enough to make the metric move, if they come with more downside volatility.

Sortino Ratio = Return / Downside Volatility

Over the 10- and 15-year periods ending January 31, 2018, the Sortino Ratio for the S&P 500 Index was 0.99% and 1.08%, respectively, according to Morningstar. But over the past 3- and 5-year periods, the Sortino Ratio for the index has been 2.67% and 3.10%, respectively. Clearly we’ve been spoiled with 3- and 5-year periods of high returns with little downside volatility – around triple the ratio of the longer term periods. Over long periods of time, the market doesn’t deliver such robust high volatility-adjusted returns.

Source: Morningstar

Ironically, the fraudulent Sortino Ratio of Bernie Madoff’s hedge fund was 2.95%. Madoff didn’t advertise market-beating returns, but returns that were close enough to the market’s with hardly any volatility. Somehow – probably with the help of very low interest rates and investor psychology – we’ve gotten a Sortino Ratio over the last 3 and 5 years that roughly matches that of the Madoff fraud.

Continue Reading at Real Investment Advice

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