A thoughtful reader sent me a kind comment that he prefers the Sortino ratio over the Sharpe ratio to estimate the risk of stocks. The Sortino ratio only penalizes the downside risk, whereas the Sharpe ratio judges risk by both upside and downside risk.

The reason I do not favor the Sortino ratio is because I feel there is the risk that an investor, in seeking to pursue capital gains, may subconsciously fantasize that a stock is a winner that can only go up and then he may engage in confirmation bias by only in taking news that supports his view. For example here in Silicon Valley during tech bubbles investors fall in love with tech stocks that have high P.E. ratios and which may have stock price that is rapidly ascending. Suppose a stock has been going up a lot with minimal down days. Then a database composed only of downward movements would miss key data about potential risk that is embedded in the “good news” of a parabolic stock price increase. During a bubble some investments that are incorrectly favored by crowds of naïve investors will have the stock price bid up to excessive heights. It is important to be aware of extreme upward movements and to incorporate that data as a measure of risk. Surely, if a stock goes up way too fast that is a tip off of a potnetial risk.

    Life is unfair. Investors sometimes behave in a herd-like manner and make irrational emotional mistakes and overpay for stocks, creating a bubble and spoiling the attempts of rational analysts to predict the market. To attempt to become aware of risk it is vital include the parabolic upward movement of an investment into a database as one of many tools to use to assess risk. Imagine an airplane climbing and never dropping in altitude and going parabolic. Eventually it will lose its airfoil and stall out and it may not be able to pull out of steep decline caused by the stall out before crashing. So the pilot needs, as one of many tools, to gauge risk by examining the excessive rate of ascent. This is not available in Sortino ratios.

prepare for a crashPrepare for a stall out

Prepare and test for stall outs

A better way to gauge downside risk might be to look at fundamentals as Buffett does. For example look at the corporate moat to see how well can the company defend against competition. Look at earnings growth and look at stability of earnings during the last recession to see how well the firm can withstand a recession. Examine the ratio of debt to income to see if the company will have trouble servicing debt.

The problem with Sortino, Sharpe, and Information ratios is that they use the stock price as a key part of their data. But stock prices are frequently the domain of irrational investors caught up in the emotions of a bubble mania. By contrast, corporate earnings, sales, and liabilities are easily documented facts, are more steady and less influenced by emotional investors. (Corporate assets can be overvalued due to a bubble or due to refusal to use mark-to-market accounting). So by seeking to judge a company on the quality, durability, stability of its earnings is a better way to judge risk than following the results of the “Keynesian beauty contest” popularity vote also known as the stock market’s price.

I have written about Sharpe ratio and Information ratio in “Increasing results using risk aware investing” and “Sharpe versus Information ratio” on February 16, 2011.

Investors should seek independent financial advice.