Goldman Sachs suggests investors look for strong performance among Standard & Poor’s 500 information technology and consumer discretionary stocks with high “idiosyncratic risk.”
Idosyncratic risk, or IR, is defined as the estimated standard deviation of stock returns not explained by a three-factor Fama and French model. That model uses three variables to explain stock returns: the return of the entire market, the performance of smallcaps minus that of largecaps and valuation based on book value.
IR is a better predictor of stock performance compared to correlation or dispersion analysis, according to the Goldman Sachs Group (GS)Â portfolio strategy research team. When IR is low, a portfolio managers’ in-depth, single-stock analysis tends to underperform. Goldman’s bullet points on idiosyncratic risk:
- In 2011 the average IR of S&P 500 stocks reached a 40 year low.
- Idiosyncratic risk accounts for 60% of a stockÂs total returns on average since 1975 but made up less than 50% of total return in 2011.
- The information technology and consumer discretionary sectors have the highest average IR, making them the most fertile for stock picking.
The following stocks have high IR, and could outperform, Goldman says:
