simulationconsu...'s  Instablog

Most investors go through a screening process in which they discard or rule in certain stocks based on performance criteria. Rather than relying on year-on-year returns, some investors use performance benchmarks instead.

The most popular is the Sharpe Ratio. This is the effective return of the investment divided by its standard deviation. There are two major failings through. The first is that the Sharpe Ratio assumes the investment returns are normally distributed; this isn't always the case (indeed, it's hardly ever the case). Secondly, upside volatility is treated the same as downside volatility; most investors want more of the former, however, and less of the later.

The Sortino Ratio attempts to wallpaper over some of the Sharpe Ratio's failings by only penalizing downside volatility. It's still only a half-way measure though.

I much prefer the Omega Ratio. It was developed in 2001 by Shadwick and Keating. It neatly captures all of the information in the returns distribution (without placing any assumptions on it). While still being easy to calculate (it's a simple one-line job in Excel), it's very flexible and far more intuitive to appreciate.