Times are tough in the crypto world.

Cryptocurrencies have shed ~$600 billion in market cap from the peaks of early 2018, and the once glorious euphoria of daily gains has all been erased from the minds of investors.

You know cryptocurrencies are “risky”, that cryptocurrencies are “speculative”…but what does that mean?

As we embrace this new market, it’s critical that we try to understand what’s going on. Risk comes in many forms, at both the micro-level (e.g., personal investments) and macro-level (e.g., prevention of market crashes and major loss of capital).

Total Returns are not adjusted for risk

Let’s take the following quiz…one is the right answer, but you won’t be graded for it.

Which of the following investments would you rather be in?

Crypto A started at $1, went to $500, back down to $1, back up to $600 Crypto B started at $1, went to $100, to $300, to $600

Both investments have the same return, but which would you choose?

I’ll give you some ti…oh you already have an answer? You choose #2?

Exactly.

Most investors look at total returns over various timeframes — one-day, one-month, one-year — when evaluating an investment. These returns are misleading since they aren’t adjusted for risk.

So what is a better way to assess the performance of an asset?

Enter the Sortino Ratio.

Risk-adjusted returns using Sortino Ratio

From Red Rock Capital:

The Sortino ratio is a modification of the Sharpe ratio but uses downside deviation rather than standard deviation as the measure of risk — i.e. only those returns falling below a user-specified target, or required rate of return are considered risky.

R = The average period return

T = The target, or required rate of return for the investment strategy under considerations.

TDD = Defined as the root-mean-square of the deviations of the realized return’s underperformance from the target return where all returns above the target return are treated as underperformance of 0.

Sortino ratio is compared often to the Sharpe Ratio (which I cover further below in the article) but is a better choice is many ways:

Sortino Ratio is better when measuring and comparing the performance of managers whose programs exhibit skew in their return distributions.

The Sortino ratio focuses strictly on downside volatility. The theory is that an investor should welcome wild swings to the upside, so upside returns are omitted.

From “Assessing skewness and kurtosis in the returns distribution” evestment.com

Cryptocurrencies are a great candidate for Sortino as the returns typically fall outside of a normal distribution.

Top 100 Cryptocurrencies by Sortino Ratio