Sharpe, Sortino, and Maximum Drawdown

Why this matters

Suppose one fund returned 12% a year and another returned 9%. The first looks better. Now suppose the first swung twice as widely to get there. Whether it's still better depends on how much risk you wanted, and on whether the same 12% could have been reached with less of it. Risk-adjusted measures put investments with different levels of risk on a common footing. The three in this lesson are ones you'll meet on fund fact sheets and in performance reports.

The Sharpe ratio

The Sharpe ratio asks how much return an investment earned above a risk-free alternative, for each unit of volatility.

Sharpe ratio = (Average return − Risk-free return) ÷ Standard deviation

The return above the risk-free rate is called the excess return. Subtracting it matters, because anyone can earn the risk-free rate with no risk at all. What's being measured is the reward for taking risk.

The figures use Aswath Damodaran's yearly data, with 3-month Treasury bills, which averaged 3.42%, as the risk-free return, and they leave out fees, taxes, and inflation.¹

Two things stand out. The 60/40 mix has a higher Sharpe ratio than shares and a much higher one than bonds, although its return is lower than that of shares. Combining two assets that didn't move together produced more return per unit of risk than either gave alone. That's diversification again, this time showing up as efficiency. And the smallest companies, with by far the highest return, have a lower Sharpe ratio than the S&P 500. They paid more, and they paid less for each unit of risk.

What the Sharpe ratio hides

• It treats all volatility as bad. A year far above average raises the standard deviation as much as a year far below it.
• It assumes standard deviation captures the risk. Distributions, Standard Deviation, and Fat Tails showed that it understates extremes. A strategy that earns small, steady gains and occasionally loses a great deal can show an excellent Sharpe ratio for years, until the loss arrives.
• It rewards smooth reported returns. An asset that isn't priced every day, such as private property or a private fund, can show less volatility than a traded one, because its value is estimated and updated slowly. Its Sharpe ratio looks better for a reason that has nothing to do with risk.
• It's a noisy estimate. The first lesson of this track put the average return on shares somewhere between about 8.0% and 15.7%. Run those through the formula and the Sharpe ratio of shares is somewhere between about 0.24 and 0.63. The difference between 0.44 and 0.46 in the table is well inside that noise.

The Sortino ratio

The Sortino ratio answers the first objection. It replaces the standard deviation with downside deviation, which counts only the years that fell short of a target and ignores the rest.

Sortino ratio = (Average return − Target return) ÷ Downside deviation

To find the downside deviation, take each year's shortfall below the target, counting years above it as zero. Square the shortfalls, average them over all the years, and take the square root.

The target is 3% a year.

Year	Return	Shortfall below 3%	Squared
1	+18%	0	0
2	−7%	−10	100
3	+12%	0	0
4	−1%	−4	16
5	+23%	0	0
Average of the squares			23.2
Downside deviation			4.8%

The average return is 9%, so the Sortino ratio is (9% − 3%) ÷ 4.8% = 1.25. The standard deviation of the same five returns is 12.7%, which gives a Sharpe ratio of 0.47. The big years of +18% and +23% inflate the standard deviation and leave the downside deviation untouched.

The ranking changes. The smallest companies go from third to first, because much of their huge volatility was on the upside: their best year was a gain of 146.6%.¹ Whether that makes them the better investment is another matter. Their downside deviation is still the largest of the four by a wide margin, and the next section shows what holding them was like.

Maximum drawdown

Maximum drawdown is the largest fall from a peak to a later low. It isn't an average of anything. It's the worst stretch an investor in that asset had to sit through, and Drawdowns and the Math of Recovery explained why deep ones are so hard to come back from.

Calculated from the same yearly data, with dividends and interest reinvested and before inflation.¹ Year-end figures understate the true falls, because the lowest point rarely comes on December 31.

The table says things the ratios can't. The asset with the best Sortino ratio lost 84% of its value in three years. The "safe" asset, Treasury bonds, had its worst fall on record in the last few years and hadn't made it back by the end of 2025. And the 60/40 mix, for all its efficiency, still lost two fifths of its value once.

Drawdown matters for two practical reasons. The first is behaviour: an investor who sells near the bottom turns a temporary fall into a permanent loss, and the deeper the fall, the harder it is to hold on. The second is withdrawals: someone taking money out during a drawdown sells more units at low prices, which Sequence Risk covers.

Its weakness is that it's a single event. A maximum drawdown depends entirely on whether the period measured happens to include a crash, and a longer record can only make it worse. A fund that started in 2010 has no 2008 in its history.

Three measures, three questions

They're best read together, over the longest period available, and against a fair benchmark over the same period, for the reasons in Alpha and Benchmark Selection.

Key takeaways

• The Sharpe ratio is the return above the risk-free rate divided by the standard deviation.
• The Sortino ratio divides by downside deviation, so gains above the target don't count as risk.
• Maximum drawdown is the largest fall from a peak to a later low.
• From 1928 through 2025, a 60/40 mix had a higher Sharpe ratio than shares or bonds alone.
• All three depend on the period measured, and none of them replaces looking at the whole record.

Check your understanding

Fund A returned 9% a year with a standard deviation of 12%. Fund B returned 12% with a standard deviation of 20%. The risk-free rate was 3%. Which had the higher Sharpe ratio?

1. Fund A, at 0.50 against 0.45 for Fund B.
2. Fund B, since its return was higher.
3. Neither, since both come to 0.60.

An investment's value at the end of five years runs $100, $130, $91, $110, $143. What was its maximum drawdown?

1. 9%, the fall from the starting $100 to the low of $91.
2. 39%, the $39 fall from the peak, as a share of $100.
3. 30%, the fall from the peak of $130 to the low of $91.

What's next

One more measure deserves a lesson to itself. Value at Risk and Expected Shortfall covers what a value-at-risk figure claims and how often it has been wrong.