CU-MBA-SEM-IV-Behavioral Finance and Analytics

1. With a ______ conventional economics is assuming not only that one set of preferences exists for the entire population, but also that only one type of preference is rational — this is to maximize income and wealth. a. agent b. investor c. representative agent d. individual 2. A typical assumption in contemporary economics is that your demand curve is ______ by the opinions and behaviors of others. a. affected b. unaffected c. influenced d. clear 3. An important hypothesis of conventional economics is that everyone is endowed with______ and, therefore, with free choice. a. freedom b. compulsion c. goals d. free will 4. People’s choices are their own, and their choices reflect their______ . a. preferences b. compulsion c. forces d. influences 5. ______ , often enforced by social ostracism and legalized forms of violence, can set powerful constraints on choice behavior. a. Habits b. Social Norms c. Goals d. Family Pressure Answer 201 1-c, 2-b, 3-d, 4-a, 5-b 10.14 REFERENCES CU IDOL SELF LEARNING MATERIAL (SLM)

 Shiller, R. J., 2000, Irrational Exuberance (Princeton University Press, Princeton, New Jersey), p. 57.  Hirshleifer, D., and T. Shumway, 2003, “Good day sunshine: Stock returns and the weather,” Journal of Finance 58(3), 1009– 1032.  Kamstra, M. J., L. A. Kramer, and M. D. Levi, 2002, “Losing sleep at the market: The daylight saving anomaly,” American Economic Review 90(4), 1005–1011.  Edmans, A., D. Garcia, and O. Norli, 2007, “Sports sentiment and stock returns,” Journal of Finance  Ackert, L. F., and B. K. Church, 2001, “The effects of subject pool and design experience on rationality in experimental asset markets,” Journal of Psychology and Financial Markets 2(1), 6–28; Jamal, K., and S. Sunder, 1996, 202 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT 11 - PSYCHOGRAPHIC MODELS OF INVESTOR BEHAVIOUR STRUCTURE 11.0 Learning Objectives 11.1 Introduction 11.2 Psychographic Models Of Behaviour 11.3 Early Psychographic Models 11.3.1 Barnewall Two-Way Model 11.3.2 Bailard, Biehl, And Kaiser Five-Way Model 11.4 The Behavioral Alpha Process: A Top-Down Approach 11.5 Summary 11.6 Keywords 11.7 Learning Activity 11.8 Unit End Questions 11.9 References 11.0 LEARNING OBJECTIVES After studying this unit, you will be able to:  Understand the various psychographic models of investor psychology.  Classify and Differentiate between various types of investors by interacting with them  Understand the specific biases of the investors  Design the questionnaire to identify investor behaviour  Develop an understanding of dealing with various clients  Learn to identify the fears using the questionnaire method 11.1 INTRODUCTION Since the popping of both the technology stock bubble in March of 2000 and subsequent popping of the credit bubble in 2008, behavioral finance has taken center stage with the financial advisory world. But for many financial advisors and individual investors—from now on I will call them, collectively, Financial Market Participants or FMPs—behavioral finance is still an unfamiliar and unused subject. There are many FMPs, however, who have 203 CU IDOL SELF LEARNING MATERIAL (SLM)

taken the time to read and learn about behavioral finance and use it in practice with good results. Why have they done so? These FMPs realize that being successful is just as much about understanding behavior as it is about understanding financial analysis. And they have observed that behavioral finance can provide tools that can help them “get inside” the head of themselves and their clients. In this chapter, we will be exploring a way to easily apply behavioral finance in practice by segmenting investors by their behavioral traits. Much of current economic and financial theory is based on the assumptions that individuals act rationally and consider all available information in the decision- making process. Behavioral finance challenges these assumptions. Psychographic models classify individuals according to certain characteristics, tendencies, or behaviors. By segmenting individuals by personality type and gender and correlating these variables with specific investor biases, we can lay the groundwork for applying many of the biases that behavioral finance literature explores (e.g., Khaneman and Tversky). If certain groups of investors prove susceptible to certain biases, then practitioners can recognize behavioral tendencies before investment decisions are made and, likely, produce better investment outcomes. Psychographic classifications are particularly relevant with regard to individual investment strategy and risk tolerance. An investor's background, past experiences, and attitudes can play a significant role in decisions made during the asset allocation process. It is important to note that because psychology is involved, no exact diagnosis can be made of any individual or situation. Although there are limitations to this type of analysis, if financial market participants can gain an understanding of their behavioral tendencies, the result is likely to be better investment outcomes. 11.2 PSYCHOGRAPHIC MODELS OF BEHAVIOUR Two studies—Barnewall, and Bailard, Biehl, and Kaiser (BB&K) — apply useful models of investor psychographics and will be reviewed in the next section. However, both studies predate significant findings in the behavioral finance literature, including important biases discovered in recent years. Further, the models Barnewall and BB&K applied leave out REFERENCES to specific behavioral biases. The Barnewall model—one of the first and most used— distinguished investors by their passivity or activity in creating wealth. Although it usefully described certain individual investors, and can be used in the behavioral investor type diagnostic process, it has limitations. For example, investors aren't just differentiable according to how they've arrived at their wealth. They are, after all, human beings and possess unique, complicated, intellectual and emotional attribute arrays. Moreover, investors are gendered. It might seem regressive to suggest that gender identity preordains financial decision making, and we certainly don't go that far. However, our data does strongly insinuate that when it comes to investing, men and women reason differently. Barnewall didn't take any of these factors into account. The modern investment era demands 204 CU IDOL SELF LEARNING MATERIAL (SLM)

a better model. The BB&K model featured some of the principles of the Barnewall model; but, by classifying investor personalities according to level of confidence and method of action, it introduced additional segmentation. Like the Barnewall model, the BB&K model is useful in working with certain clients and may explain in general terms why a person is predisposed to certain investor behaviors. However, the BB&K model neither scientifically described personality type nor links investor behaviors with recently identified investor biases, limiting its utility. As noted, neither study had the benefit of the behavioral finance literature that informs this book. 11.3 EARLY PSYCHOGRAPHIC MODELS We will now review these two models of investor psychographics from the 1980s. We will then move to more recent models of investor behavior. 11.3.1 Barnewall Two-Way Model One of the oldest and most prevalent psychographic investor models, based on the work of Marilyn MacGruderBarnewall and intended to help investment advisers interface with clients, distinguishes two relatively simple investor types: passive and active. Barnewall notes that “passive investors” are defined as those investors who have become wealthy passively—for example, by inheritance or by risking the capital of others rather than risking their own capital (managers who benefit when their companies do well are examples of the latter category). Passive investors have a greater need for security than they have tolerance for risk. Occupational groups that tend to have passive investors include corporate executives, lawyers with large regional firms, certified public accountants (CPA) with large CPA companies, medical and dental non-surgeons, small business owners who inherited the business, politicians, bankers, and journalists. Further, the smaller the economic resources an investor has, the more likely the person is to be a passive investor. The lack of resources gives individuals a higher security need and a lower tolerance for risk. “Active investors” are individuals who have been actively involved in wealth creation through investment, and they have risked their own capital in achieving their wealth objectives. Active investors have a higher tolerance for risk than they have need for security. Related to their high risk tolerance is the fact that active investors prefer to maintain control of their own investments. Their tolerance for risk is high because they believe in themselves. When active investors sense a loss of control, their risk tolerance drops quickly. They are involved in their own investments to the point that they gather tremendous amounts of information about the investments. By their involvement and control, they feel that they reduce risk to an acceptable level, which is often fallacious (Barnewall 1987). Barnewall's work suggests that a simple, non-invasive overview of an investor's personal history and career record could signal potential pitfalls to guard against in establishing an 205 CU IDOL SELF LEARNING MATERIAL (SLM)

advisory relationship. Her analysis also indicates that a quick, biographic glance at a client could provide important context for portfolio design. 11.3.2 Bailard, Biehl, and Kaiser Five-Way Model The Bailard, Biehl, and Kaiser (BB&K) model features some of the principles of the Barnewall model, but by classifying investor personalities along two axes— level of confidence and method of action—it introduces an additional dimension of analysis. Bailard, Biehl, and Kaiser (1986) provide a graphic representation of their model. Kaiser (1990) explains: Figure 11.1 Bailard, Biehl, and Kaiser Model 206 CU IDOL SELF LEARNING MATERIAL (SLM)

The first (aspect of personality) deals with how confidently the investor approaches life, regardless of whether it is his approach to his career, his health, or his money. These are important emotional choices, and they are dictated by how confident the investor is about some things or how much he tends to worry about them. The second element deals with whether the investor is methodical, careful, and analytical in his approach to life or whether he is emotional, intuitive, and impetuous. These two elements can be thought of as two “axes” of individual psychology; one axis is called the “confident–anxious” axis and the other is called the “careful–impetuous” axis.Figure BB&K Classifications This includes a synopsis of BB&K's descriptions of each of the five investor personality types that the model generates (Kaiser 1990). Although this model may be useful, it is possible that investors do not approach all parts of their life with equal confidence or care. It is important to focus on the approach to investing rather than placing undue focus on evidence from other aspects of their life. In addition, a limitation of all categorization schemes is that an individual's behavior patterns may change or lack consistency. 207 CU IDOL SELF LEARNING MATERIAL (SLM)

11.4 THE BEHAVIORAL ALPHA PROCESS: A TOP-DOWN APPROACH The Behavioral Alpha approach is a multi-step diagnostic process that results in clients being classified into one of four behavioral investor types (BITs). Bias identification, which is done near the end of the process, is narrowed down for the advisor by giving the advisor clues as to which biases a client is likely to have, based on the client's BIT. BITs were designed to help advisors make rapid yet insightful assessments of what type of investor they are dealing with before recommending an investment plan. The benefit of defining what type of investor an advisor is dealing with up-front is that client behavioral surprises that result in a client wishing to change his or her portfolio as a result of market turmoil can be mitigated. If an advisor can limit the number of traumatic episodes that inevitably occur throughout the advisory process by delivering smoother (read here: expected) investment results, because the advisor had created an investment plan that is customized to the client's behavioral make-up, a stronger client relationship is the result. BITs, however, are not intended to be “absolutes” but rather “guide posts” to use when making the journey with a client; dealing with irrational investor behavior is not an exact science. For example, an advisor may find that he or she has correctly classified a client as a certain BIT, but finds that the client has traits (biases) of another. There are four behavioral investor types: Preservers, Followers, Independents, and Accumulators. Each BIT is characterized by the type of bias that dominates an investor's personality. One of the most important concepts advisors should keep in mind as they go through these articles is that the least risk tolerant BIT and the most risk tolerant BIT are driven by emotional biases, while the two BITS in between these two extremes are mainly affected by cognitive biases. Emotional clients tend to be more difficult clients to work with and advisors who can recognize the type of client they are dealing with prior to making investment recommendations will be much better prepared to deal with irrational behavior when it arises. The Bit Identification Process Step 1: Interview client and identify active or passive traits. Most advisors begin with a client interview, which consists mainly of a question-and-answer session intended to gain an understanding about a client's objectives, constraints, and past investing practices. This interview should tell the advisor whether a client is an active or passive investor. In other words, has the client in the past (or does the client now) put capital at risk to build wealth? It is important to make a distinction between investing in a diversified portfolio and risking capital. Risking capital involves doing things such as building companies (big or small), investing in speculative real estate using leverage, or working for oneself rather than for a large company. 208 CU IDOL SELF LEARNING MATERIAL (SLM)

Understanding active and passive traits is important because passive investors tend toward certain biases and active investors tend toward different biases, which we will see later in the chapter. The below table shows questions that probe the active/passive nature of clients. A preponderance of “A” answers indicates an active investor; “B” answers indicate a passive investor. Step 2: Administer risk-tolerance questionnaire. Once the advisor has classified the investor as active or passive, the advisor administers a traditional risk-tolerance questionnaire (not included here). The expectation is that active investors will rank medium-to-high for risk tolerance and that passive investors will rank moderate-to-low for risk tolerance. Naturally, this will not always be the case. With an unexpected outcome, the advisor should defer to risk tolerance in determining which biases to test for. Figure 11.2 Biases Associated with each Behavioral Investor Type Step 3: Test for Behavioral Biases and Confirm Behavioral Investment Type (BIT). The third step is to test for and confirm that the client has certain behavioral biases. For instance, if an investor is passive, and the risk-tolerance questionnaire reveals a very low risk tolerance, the investor likely has the biases associated with a preserver. If the investor is passive and the questionnaire reveals a low-to-medium risk tolerance, the investor likely has the biases associated with a follower. If an investor is active and has a medium-to-high risk tolerance, the investor likely has the biases associated with an individualist. Finally, if an investor is active and has a high risk tolerance, the investor likely has the biases associated with an accumulator. When the client is tested for behavioral biases of a passive preserver, for example, and the test confirms that the client has these biases, then the BIT diagnosis is confirmed. The below figure provides an overview of the characteristics of each BIT and illustrates the entire diagnostic process. 209 CU IDOL SELF LEARNING MATERIAL (SLM)

Note that in the figure above clients at either end of the scale are emotionally biased in their behavior while clients in the middle are cognitively biased, which makes sense. Clients with a high need for security are emotionally driven; they get very emotional about losing money and very uneasy during times of stress or change. Similarly, very aggressive investors also are emotional. They typically suffer from overconfidence and mistakenly believe they can 210 CU IDOL SELF LEARNING MATERIAL (SLM)

control their investment outcomes. In between are the investors who mainly suffer cognitive biases and need education and information to make better investment decisions. But of primary importance is this: Clients who are emotional investors need to be advised differently than those who make mainly cognitive errors. When advising emotional investors, advisors must focus on how the investment program impacts important emotional issues such as financial security, retirement, or future generations, not quantitative details such as standard deviations and Sharpe ratios. The quantitative approach is more effective with clients who are less emotional and tend to make cognitive errors. 11.5 SUMMARY  This unit has focused on the description of the psychographic models for early investor types.  Clients with a high need for security are emotionally driven; they get very emotional about losing money and very uneasy during times of stress or change.  An investor is active and has a medium-to-high risk tolerance, the investor likely has the biases associated with an individualist.  There are four behavioral investor types: Preservers, Followers, Independents, and Accumulators.  Behavioral Alpha approach is a multi-step diagnostic process that results in clients being classified into one of four behavioral investor types (BITs). 11.6 KEYWORDS  Behavioral Alpha is a multi-step diagnostic process that results in clients being classified into one of four behavioral investor types (BITs).  Barnewall 2 Way test classifies investors as active and passive  BBK Test is called as the Bailard, Biehl, and Kaiser Model  BBK classifies investor personalities along two axes— level of confidence and method of action  Individualists – They are confident and careful. They generally do not go to a consultant to manage their investments but do it by themselves.  Adventurers – Adventurers generally go for only big bets. They have the resources to do so and are willing to take risks. The investment made by this type of investors are generally focused and not diversified.  Celebrities – Celebrities are those that are swayed too much by the trend and do not have any expertise or opinion about investments. However, not having the expertise and the confidence required to manage the portfolio on their own, they approach investment managers frequently. 211 CU IDOL SELF LEARNING MATERIAL (SLM)

 Guardians – Guardians are both anxious and careful. Lacking confidence in themselves, they approach investment counsels. They generally emphasize on safety of the capital while making the  Straight arrows – These are halfway between complete confidence and anxiety, and extreme carefulness and impetuousness. 11.7 LEARNING ACTIVITY 1. Identify your biases and classify yourself into a passive or active investor ___________________________________________________________________________ ___________________________________________________________________________ 2. Among your circle of friends or family members, find out 2 examples of each type of investor on the BBK scale. Note their qualities which make them the kind of investor you have classified them into ___________________________________________________________________________ ___________________________________________________________________________ 11.8UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. What is Behavioural Alpha? 2. Which are the two psychographic models for investor behaviour? 3. Explain the BBK test and the axes on which the personalities are classified. 4. Which are the 5 types of investors personalities based on the BBK test? 5. Who are Active investors ? 6. Who are Passive Investor? 7. According to the test specified in the table, what kind of Investor are you? Long Questions 1. Explain the Behavioural investor types in detail? 2. Explain the Behavioural Alpha and the steps to identify the various BITs? 3. Explain the 5 types of personalities according to the BBK test in detail. 4. Which are the two axes used by the BBK model? Who invented the BBK model of identification of BIT? According to you what is the difference between the BBK and the Barnewall models? 5. Why, according to you Psychographic testing and segmentation of investors in required in various classes? Can you briefly relate which asset classes can be suggested to which investor types? 212 CU IDOL SELF LEARNING MATERIAL (SLM)

B. Multiple Choice Questions 1. The ______ distinguished investors by their passivity or activity in creating wealth. a. Barnewall Model b. BBK Model c. Nudge Model d. Ironic Model 2. ______ investors are defined as those investors who have become wealthy passively. a. Active b. Independent c. Passive d. Follower 3. Passive investors have a ______ need for security than they have tolerance for risk a. Lesser b. greater c. equal d. no 4. ______ investors are individuals who have been actively involved in wealth creation through investment, and they have risked their own capital in achieving their wealth objectives. a. Active b. Passive c. Guardian d. Celebrity 5. Active investors have a______ tolerance for risk than they have need for security. a. lower b. no c. higher d. maximum Answer 1-a, 2-c, 3-b, 4-a, 5-c 11.9 REFERENCES 213 CU IDOL SELF LEARNING MATERIAL (SLM)

 Daniel Kahneman and Amos Tversky, “Prospect Theory: An Analysis of Decision under Risk,” Econometrica 47 (1979): 263–91.  M. Barnewall, “Psychological Characteristics of the Individual Investor,” in Asset Allocation for the Individual Investor, ed. William Droms (Charlottesville, VA: Institute of Chartered Financial Analysts, 1987).  Thomas Bailard, David Biehl, and Ronald Kaiser, Personal Money Management, 5th ed. (Chicago: Science Research Associates, 1986).  M. Barnewall, “Psychological Characteristics,” see note 2.  T. Bailard, D. Biehl, and R. Kaiser, Personal Money Management, see note 214 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT12- PSYCHOGRAPHIC MODELS USED IN BEHAVIOURAL FINANCE STRUCTURE 12.0 Learning Objectives 12.1 Introduction 12.2 Behavioural Investor Types 12.3 Preserver 12.4 Follower 12.5 Independent 12.6 Accumulator 12.7 Summary 12.8 Keywords 12.9 Learning activity 12.10 Unit End Questions 12.11 References 12.0 LEARNING OBJECTIVES After studying this unit, you will be able to:  You will be able to identify each of the behavioural investor types  Understand their biases in detail  Survey the various types of investors and their risk behaviours  Assess the biases of different investor types  Compile the instructions and advice to be given 12.1 INTRODUCTION This chapter describes the various characteristics and biases of the investors classified as per the BBK 5 Way Model. Behavioral investor types (BITs) were designed to help financial market participants (FMPs) make a speedy yet insightful assessment of what type of biases dominate investment decision making. There are 4 identified types of BITs: the Preserver, the Follower, the Independent, and the Accumulator. 215 CU IDOL SELF LEARNING MATERIAL (SLM)

One of the most important concepts readers should keep in mind as they go through the next four sections in this chapter is that the least risk-tolerant BIT and the most risk-tolerant BIT clients are emotionally biased in their behavior. In the middle of the risk scale are BITs that are affected mainly by cognitive biases. Even if advisors had been trained in irrational biases, could understand how to apply this knowledge to their clients, and could communicate in industry standard parlance, they still needed a way to make the process efficient, almost second nature, in terms of incorporating behavioral finance into the everyday practice of providing financial advice. In other words, advisors needed to be able to adroitly recognize investor behavior at a high level, so they could quickly and effectively diagnose and treat that client's irrational behavior. The method for doing this, as we will see in this chapter, is called Behavioral Alpha. The word “alpha” is used for two reasons. First, the dictionary definition of alpha is “first” or “the beginning.” It is my belief that before an asset allocation is created, financial advisors first need to take inventory of a client's behavior—hence behavioral alpha. Secondly, in the context of the financial world, the word alpha has become synonymous with describing performance above expectations. In the context of behavioral alpha, my belief is that by taking inventory of an investor's behavior prior to creating an investment plan, the advisor will have performance results that exceed expectations because the client will be able to more comfortably adhere to an allocation that has been custom-designed for them. The development of behavioral investor types or BITs is essentially a continuation and refinement of my previous work in the aforementioned JFP article published in March 2003 and was intended to get behavioral finance over the proverbial “goal line;” to a place where FMPs feel more confident that they can use behavioral finance easily and effectively in practice. 12.2 BEHAVIOURAL INVESTOR TYPES Each BIT has biases that are associated with it, which will be discussed extensively in the next section. BITs are not intended to be “absolutes” but rather “guideposts.” For example, you may find that you have classified yourself or a client as a Preserver, but find that they have traits (biases) of a Follower or even an Individualist. The grouping or clustering of biases to define a BIT is done to show that certain investors have a strong tendency to certain biases that can dominate investment decision-making behavior. The goal of the use of BITs is to discover irrational behaviors and then, ultimately, to create a behaviorally modified (best practical) asset allocation (that we learned about in earlier chapters) that FMPs can comfortably adhere to, to meet long-term financial goals. This should make intuitive sense. Investors who have a high need for security (i.e., a low risk tolerance) do so because emotion is driving this behavior; they get emotional about losing 216 CU IDOL SELF LEARNING MATERIAL (SLM)

money and get uneasy during times of stress or change. Similarly, highly aggressive investors are also emotionally charged people who adamantly want to accumulate assets. They typically suffer from a high level of overconfidence and mistakenly believe they can control the outcomes of their investments. In between these two extremes are the investors who suffer mainly from cognitive biases and can benefit from education and information about their biases so they can make better investment decisions. A brief diagnostic is provided for each of the biases associated with each BIT. Advice, which is geared toward the advisor, is also provided. An overarching point that readers should keep in mind as they proceed is that investors who are emotional about their investing need to be advised differently than those who make mainly cognitive errors. When advising emotionally charged investors, advisors need to focus on how the investment program being created impacts important emotional issues like financial security, retirement, or the goals for future generations rather than focusing on portfolio details like standard deviation and Sharpe ratios. A quantitative approach is more effective with clients who are less emotional and tend to make cognitive errors. Emotional clients tend to be more difficult clients to work with, and advisors who can recognize the type of client they are dealing with prior to making investment recommendations will be much better prepared to deal with irrational behavior when it arises. At the end of the day, the goal is to build better long-term relationships with clients; BITs are designed to help in this effort. In the next section, we begin with a passive, conservative investor, the Preserver. 12.3 PRESERVER Basic type: Passive Risk tolerance level: Low Primary bias: Emotional Preservers are, as the name implies, passive investors who place a great deal of emphasis on financial security and preserving wealth rather than taking risk to grow wealth. Because they have gained wealth by not risking their own capital, Preservers may not be highly financially sophisticated. A common situation is a Preserver who has gained wealth through inheritance or conservatively by working in a large company. Some Preservers are “worriers” in that they obsess over short-term performance (losses) and are slow to make investment decisions because they aren't entirely comfortable with change—which is consistent with the way they have approached their professional lives—being careful not to take excessive risks. Many Preservers are focused on taking care of their family members and future generations, especially funding life-enhancing experiences such as education and home buying. Because the focus is on family and security, Preserver biases tend to be emotional rather than cognitive. As age and wealth level increase, this BIT becomes more common. Although not 217 CU IDOL SELF LEARNING MATERIAL (SLM)

always the case, many Preservers enjoy the wealth management process—they like the idea of being catered to because of their financial status—and thus are generally good clients. Behavioral biases of Preservers tend to be emotional, security-oriented biases such as endowment bias, loss aversion, and status quo. Preservers also exhibit cognitive biases such as anchoring and mental accounting. The following is a description of the biases just discussed (this should be a review for you) and a simple diagnostic for each bias. Loss Aversion Bias Bias type: Emotional Preservers tend to feel the pain of losses more than the pleasure of gains as compared to other client types. As such, these Preservers may hold on to losing investments too long—even when they see no prospect of a turnaround. Loss aversion is a very common bias and is seen by large numbers of financial advisors with this type of client. Simple diagnostic for loss aversion bias: On a scale of 1 to 5, with 5 being full agreement, how much do you agree with the following? Answering 3 to 5 shows a tendency toward loss aversion bias. Status Quo Bias Bias type: Emotional Preservers often prefer to keep their investments (and other parts of their life for that matter) the same or keep the “status quo.” These investors tell themselves “things have always been this way” and thus feel safe keeping things the same. Simple diagnostic for status quo bias: On a scale of 1 to 5, with 5 being full agreement, how much do you agree with the following? When considering changing my portfolio, I spend time thinking about options but often end up changing little or sometimes nothing. Answering 3 to 5 shows a tendency toward status quo bias. EndowmentBias Bias type: Emotional Preservers, especially those who inherit wealth, tend to assign a greater value to an investment they already own (such as a piece of real estate or an inherited stock position) than they would if they didn't possess that investment and had the potential to acquire it. Simple diagnostic for endowment bias: On a scale of 1 to 5, with 5 being full agreement, how much do you agree with the following? I sometimes get attached to certain of my investments, which may cause me not to take action on them. 218 CU IDOL SELF LEARNING MATERIAL (SLM)

Answering 3 to 5 shows a tendency toward endowment bias. Anchoring Bias Bias type: Cognitive Investors in general, and Preservers in particular, are often influenced by purchase points or arbitrary price levels, and tend to cling to these numbers when facing questions like “should I buy or sell this investment?” Suppose that the stock is down 25 percent from the high that it reached five months ago ($75/share vs. $100/share). Frequently, a Preserver client will resist selling until its price rebounds to the $100/share it achieved five months ago. Simple diagnostic for anchoring bias: On a scale of 1 to 5, with 5 being full agreement, how much do you agree with the following: When thinking about selling an investment, the price I paid is a big factor I consider before taking any action. Answering 3 to 5 shows a tendency toward anchoring bias. Mental Accounting Bias Bias type: Cognitive Many Preservers treat various sums of money differently based on where these sums are mentally categorized. For example, Preservers often segregate their assets into safe “buckets.” If all of these assets are viewed as safe money, suboptimal overall portfolio returns are usually the result. Simple diagnostic for mental accounting bias: On a scale of 1 to 5, with 5 being full agreement, how much do you agree with the following: I tend to categorize my investments in various accounts, for example, leisure, bill pay, college funding, etc. Answering 3 to 5 shows a tendency toward mental accounting bias. Advice for Preservers After reviewing this section, readers might correctly conclude that Preservers are difficult to advise because they are driven mainly by emotion. This is true; however, they are also greatly in need of good financial advice. Advisors should take the time to interpret behavioral signs provided to them by Preserver clients. Preservers need “big picture” advice, and advisors shouldn't dwell on details like standard deviations and Sharpe ratios or else they will lose the client's attention. Preservers need to understand how the portfolio they choose to create will deliver desired results to emotional issues such as family members or future generations. Once they feel comfortable discussing these important emotional issues with their advisor, and a bond of trust is established, they will take action. After a period of time, Preservers are 219 CU IDOL SELF LEARNING MATERIAL (SLM)

likely to become an advisor's best clients because they value greatly the advisor's professionalism, expertise, and objectivity in helping make the right investment decisions. 12.4FOLLOWER Basic type: Passive Risk tolerance level: Low to medium Primary bias: Cognitive Followers are typically passive investors who do not have their own ideas about investing. They often follow the lead of their friends and colleagues in investment decisions, and want to be in the latest, most popular investments without regard to a long-term plan. One of the key challenges of working with Followers is that they often overestimate their risk tolerance. Advisors need to be careful not to suggest too many “hot” investment ideas—Followers will likely want to do all of them. Some don't like, or even fear, the task of investing, and many put off making investment decisions without professional advice; the result is that they maintain, often by default, high cash balances. Followers generally comply with professional advice when they get it, and they educate themselves financially, but can at times be difficult because they don't enjoy or have an aptitude for the investment process. Biases of Followers are cognitive: recency, hindsight, framing, regret, cognitive dissonance, and outcome. Recency Bias Bias type: Cognitive Recency bias is a predisposition for investors to recall and emphasize recent events and/or observations. Followers may extrapolate patterns where none really exist. Recency bias ran rampant during the bull market period between 2003 and 2007 when many investors wrongly presumed that the stock market, particularly energy, housing, and international stocks, would continue gains. Moderate investors are known to enter or hold on to investments when prices are peaking, which can end badly, with sharp price declines. Simple diagnostic for recency bias: On a scale of 1 to 5, with 5 being full agreement, how much do you agree with the following: When considering the track record of an investment, I put more weight on how it has performed recently versus how it has performed historically. Answering 3 to 5 shows a tendency toward recency bias. Hindsight Bias Bias type: Cognitive 220 CU IDOL SELF LEARNING MATERIAL (SLM)

Followers often lack independent thoughts about their investments and are susceptible to hindsight bias, which occurs when an investor perceives investment outcomes as if they were predictable. The result of hindsight bias is that it gives investors a false sense of security when making investment decisions, emboldening them to take excessive risk without recognizing it. Simple diagnostic for hindsight bias: On a scale of 1 to 5, with 5 being full agreement, how much do you agree with the following: When reflecting on past investment mistakes, I see that many could have been easily avoided. Answering 3 to 5 shows a tendency toward hindsight bias. Framing Bias Bias type: Cognitive Framing bias is the tendency of Followers to respond to situations differently based on the context in which a choice is presented (framed). Often, Followers focus too restrictively on one or two aspects of a situation, excluding other considerations. The use of risk tolerance questionnaires provides a good example. Depending on how questions are asked, framing bias can cause investors to respond to risk tolerance questions in an either unduly risk-averse or risk-taking manner. For example, when questions are worded in the gain frame (e.g., an investment goes up), then a risk-taking response is more likely. When questions are worded in the “loss” frame (e.g., an investment goes down), then risk-averse behavior is the likely response. Simple diagnostic for framing bias: On a scale of 1 to 5, with 5 being full agreement, how much do you agree with the following: I trust more the advice of national investment firms than smaller, local firms. Answering 3 to 5 shows a tendency toward framing bias. Cognitive Dissonance Bias Bias type: Cognitive In psychology, cognitions represent attitudes, emotions, beliefs, or values. When multiple cognitions intersect–for example when a person believes in something only to find out it is not true—Followers try to alleviate their discomfort by ignoring the truth and/or rationalizing their decisions. Investors who suffer from this bias may continue to invest in a security or fund they already own after it has gone down (average down) even when they know they should be judging the new investment with objectivity. A common phrase for this concept is “throwing good money after bad.” Simple diagnostic for cognitive dissonance bias: On a scale of 1 to 5, with 5 being full agreement, how much do you agree with the following: 221 CU IDOL SELF LEARNING MATERIAL (SLM)

When making investment decisions, I tend to focus on the positive aspect of an investment rather than on what might go wrong with the investment. Answering 3 to 5 shows a tendency toward cognitive dissonance bias. Regret Aversion Bias Bias type: Emotional Followers often avoid taking decisive actions because they fear that, in hindsight, whatever course they select will prove less than optimal. Regret aversion can cause some investors to be too timid in their investment choices because of losses they have suffered in the past. Simple diagnostic for regret aversion bias: On a scale of 1 to 5, with 5 being full agreement, how much do you agree with the following: Poor past financial decisions have caused me to change my current investing behavior. Answering 3 to 5 shows a tendency toward regret aversion bias. Advice for Followers Advisors to Followers first and foremost need to recognize that Followers often overestimate their risk tolerance. Risky trend-following behavior occurs in part because Followers don't like situations of ambiguity that may accompany the decision to enter an asset class when it is out of favor. They also may convince themselves that they “knew it all along” when an investment idea goes their way, which also increases future risk-taking behavior. Advisors need to handle Followers with care because they are likely to “say yes” to investment ideas that make sense to them, regardless of whether the advice is in their best long-term interest. Advisors need to encourage Followers to take a hard look at behavioral tendencies that may cause them to overestimate their risk tolerance. Because Follower biases are mainly cognitive, education on the benefits of portfolio diversification and sticking to a long-term plan is usually the best course of action. Advisors should challenge Follower clients to be introspective and provide data-backed substantiation for recommendations. Offering education in clear, unambiguous ways so they have the chance to “get it” is a good idea. If advisors take the time, this steady, educational approach will generate client loyalty and adherence to long-term investment plans. 12.5INDEPENDENT Basic type: Active Risk tolerance: Medium to high Primary bias: Cognitive With Independents, we are entering the realm of the active investor. As we reviewed in earlier articles, these investors have been actively involved in their wealth creation, typically 222 CU IDOL SELF LEARNING MATERIAL (SLM)

risking their own capital in achieving their wealth objectives. Active investors have a higher tolerance for risk than they have need for security. Their tolerance for risk is high because they believe in themselves. Related to their high risk tolerance is the fact that active investors prefer to maintain at least some amount of control of their own investments. They want to get very involved in investment decision making and aren't afraid to roll up their sleeves and do due diligence on contemplated investments. Let's turn our attention to the first of two active behavioral investor types, the Independent Individualist (II). An Independent is an active investor with medium-to-high risk tolerance who is strong-willed and an independently minded thinker. Independents are self- assured and “trust their instincts” when making investment decisions; however, when they do research on their own, they may be susceptible to acting on information that is available to them rather than getting corroboration from other sources. Sometimes advisors find that an Independent client made an investment without consulting anyone. This approach can be problematic because, due to their independent mind-set, these clients often irrationally cling to the views they had when they made an investment, even when market conditions change, making advising Independents challenging. They often enjoy investing, however, and are comfortable taking risks, but often resist following a rigid financial plan. Some Independents are obsessed with trying to beat the market and may hold concentrated portfolios. Of all behavioral investor types, Independents are the most likely to be contrarian, which can benefit them—and lead them to continue their contrarian practices. Independent Individualist biases are cognitive: conservatism, availability, confirmation, representativeness, and self-attribution. Conservatism Bias Bias type: Cognitive Conservatism bias occurs when people cling to a prior view or forecast at the expense of acknowledging new information. Independents often cling to a view or forecast, behaving too inflexibly when presented with new information. For example, assume an investor purchases a security based on the knowledge about a forthcoming new product announcement. The company then announces that it is experiencing problems bringing the product to market. Independents may cling to the initial, optimistic impression of the new product announcement and may fail to take action on the negative announcement. Simple diagnostic for conservatism bias: On a scale of 1 to 5, with 5 being full agreement, how much do you agree with the following: I don't easily change my views about investments once they are made. Answering 3 to 5 shows a tendency toward conservatism bias. Availability Bias 223 CU IDOL SELF LEARNING MATERIAL (SLM)

Bias type: Cognitive Availability bias occurs when people estimate the probability of an outcome based on how prevalent that outcome appears in their lives. People exhibiting this bias perceive easily recalled possibilities as being more likely than those prospects that are harder to imagine or difficult to comprehend. As an example, suppose an Independent is asked to identify the “best” mutual funds. Many of these investors would perform a Google search and, most likely, find funds from firms that engage in heavy advertising—such as Fidelity or Schwab. Investors subject to availability bias are influenced to pick funds from such companies, despite the fact that some of the best-performing funds advertise very little if at all. Simple diagnostic for availability bias: On a scale of 1 to 5, with 5 being full agreement, how much do you agree with the following: I often take action on a new investment right away, if it makes sense to me. Answering 3 to 5 shows a tendency toward availability bias. Representativeness Bias Bias type: Cognitive Representativeness bias occurs as a result of a flawed a perceptual framework when processing new information. To make new information easier to process, some investors project outcomes that resonate with their own preexisting ideas. An Independent might view a particular stock, for example, as a value stock because it resembles an earlier value stock that was a successful investment— but the new investment is actually not a value stock. For instance, a high-flying biotech stock with scant earnings or assets drops 25 percent after a negative product announcement. Some Independents may take this situation to be representative of a “value” stock because it is cheap; but biotech stocks don't typically have earnings, while traditional value stocks have had earnings in the past but are temporarily underperforming. Simple diagnostic for representativeness bias: On a scale of 1 to 5, with 5 being full agreement, how much do you agree with the following: Many investment choices I make are based upon my knowledge of how similar past investments have performed. Answering 3 to 5 shows a tendency toward representativeness bias. Self-Attribution (Self-Enhancing) Bias Bias type: Cognitive Self-attribution bias refers to the tendency of Independents to ascribe their successes to innate talents while blaming failures on outside influences. For example, suppose an Independent makes an investment in a particular stock that goes up in value. The reason it went up is not 224 CU IDOL SELF LEARNING MATERIAL (SLM)

due to random factors such as economic conditions or competitor failures (the most likely reason for the investment success), but rather to the investor's investment savvy (likely not the reason for the investment success.) This is classic self-enhancing bias. Simple diagnostic for self-attribution bias: On a scale of 1 to 5, with 5 being full agreement, how much do you agree with the following: I often find that many of my successful investments can be attributed to my decisions, while those that did not work out were based on the guidance of others. Answering 3 to 5 shows a tendency toward self-attribution bias. Confirmation Bias Bias type: Cognitive Confirmation bias occurs when people observe, overvalue, or actively seek out information that confirms their claims, while ignoring or devaluing evidence that might discount their claims. Confirmation bias can cause investors to seek out only information that confirms their beliefs about an investment, and not seek out information that may contradict their beliefs. This behavior can leave investors in the dark regarding, for example, the imminent decline of a stock. Independents often find themselves subject to this bias. Simple diagnostic for confirmation bias: On a scale of 1 to 5, with 5 being full agreement, how much do you agree with the following: When an investment is not going well, I usually seek information that confirms I made the right decision about it. Answering 3 to 5 shows a tendency toward confirmation bias. Advice for Independents Independents can be difficult clients to advise due to their independent mindset, but they are usually grounded enough to listen to sound advice when it is presented in a way that respects their independent views. As we have learned, Independent Individualists are firm in their belief in themselves and their decisions, but can be blinded to contrary thinking. As with Followers, education is essential to changing behavior of Independents; their biases are predominantly cognitive. A good approach is to have regular educational discussions during client meetings. This way, the advisor doesn't point out unique or recent failures, but rather educates regularly and can incorporate concepts that he or she feels are appropriate for the client. Because Independents’ biases are mainly cognitive, education on the benefits of portfolio diversification and sticking to a long-term plan is usually the best course of action. Advisors should challenge Independents to reflect on how they make investment decisions and provide data-backed substantiation for recommendations. Offering education in clear, unambiguous ways is an effective approach. If advisors take the time, this steady, educational approach should yield positive results. 225 CU IDOL SELF LEARNING MATERIAL (SLM)

12.6ACCUMULATOR Basic type: Active Risk tolerance: High Primary bias: Emotional With Accumulators, we continue within the realm of the active investor. As we reviewed in earlier articles, active investors have been actively involved in their wealth creation, typically risking their own capital in achieving their wealth objectives. Active investors have a higher tolerance for risk than they have need for security. Their tolerance for risk is high because they believe in themselves. Related to their high risk tolerance is the fact that active investors prefer to get very involved in investment decision making and aren't afraid to roll up their sleeves and do due diligence on contemplated investments. Let's turn our attention now to the last of the two active behavioral investor types, the Accumulator. The Accumulator is the most aggressive behavioral investor type. These clients are entrepreneurial and often the first generation to create wealth, and they are even more strong- willed and confident than Independents. At high wealth levels, they often have controlled the outcomes of noninvestment activities and believe they can do the same with investing. This behavior can lead to overconfidence in investing activities. Left unadvised, they often trade too much, which can be a drag on investment performance. Accumulators are quick decision makers but may chase higher-risk investments than their friends. If successful, they enjoy the thrill of making a good investment. Some Accumulators can be difficult to advise because they don't believe in basic investment principles such as diversification and asset allocation. They are often “hands-on,” wanting to be heavily involved in the investment decision-making process. Biases of Accumulators are overconfidence, self-control, affinity, and illusion of control. Overconfidence Bias Bias type: Emotional Overconfidence is best described as unwarranted faith in one's own thoughts and abilities, which contains both cognitive and emotional elements. Overconfidence manifests itself in investors’ overestimation of the quality of their judgment. Many Accumulators claim an above-average aptitude for selecting stocks; however numerous studies have shown this to be a fallacy. For example, a study done by researchers Odean and Barber showed that after trading costs (but before taxes), the average investor underperformed the market by approximately 2 percent per year due to unwarranted belief in their ability to assess the correct value of investment securities. Simple diagnostic for overconfidence bias: On a scale of 1 to 5, with 5 being full agreement, how much do you agree with the following: 226 CU IDOL SELF LEARNING MATERIAL (SLM)

I am confident that my investment knowledge is above average and I can accurately predict how my investments will do. Answering 3 to 5 shows a tendency toward overconfidence bias. Self-Control Bias Bias type: Emotional Self-control bias is the tendency to consume today at the expense of saving for tomorrow. The primary concern for advisors with this bias is a client with high risk tolerance coupled with high spending. For example, suppose you have an Accumulator client who prefers high volatility investments and has high current spending needs and suddenly the financial markets hit some severe turbulence. This client may be forced to sell solid long-term investments that have had been priced down due to current market conditions just to meet current expenses. Simple diagnostic for self-control bias: On a scale of 1 to 5, with 5 being full agreement, how much do you agree with the following: I will buy things I want even if they are not the best financial choices. Answering 3 to 5 shows a tendency toward self-control bias. Affinity Bias Bias type: Emotional Affinity bias refers to an individual's tendency to make irrationally uneconomical consumer choices or investment decisions based on how they believe a certain product or service will reflect their values. Accumulators sometimes succumb to this bias. Simple diagnostic for affinity bias: On a scale of 1 to 5, with 5 being full agreement, how much do you agree with the following: I invest in companies that make products I like or companies that reflect my personal values. Answering 3 to 5 shows a tendency towards affinity bias. Illusion of Control Bias Bias type: Cognitive The illusion of control bias occurs when investors believe that they can control or, at least, influence investment outcomes when, in fact, they cannot. Accumulators who are subject to illusion of control bias believe that the best way to manage an investment portfolio is to constantly adjust it. For example, trading-oriented Accumulators who accept high levels of risk, believe themselves to possess more “control” over the outcome of their investments than they actually do because they are “pulling the trigger” on each decision. Simple diagnostic for outcome bias: On a scale of 1 to 5, with 5 being full agreement, how much do you agree with the following: 227 CU IDOL SELF LEARNING MATERIAL (SLM)

I am more likely to have a better outcome if I make my own investment choices rather than relying on others. Answering 3 to 5 shows a tendency toward outcome bias. Outcome Bias Bias type: Cognitive Outcome bias refers to the tendency of individuals to decide to do something —such as make an investment in a mutual fund—based on the outcome of past events (such as returns of the past five years) rather than by observing the process by which the outcome came about (the investment process used by the mutual fund manager over the past five years). Accumulators often are prone to outcome bias. Simple diagnostic for outcome bias: On a scale of 1 to 5, with 5 being full agreement, how much do you agree with the following: What's most important is that my investments make money—I'm not that concerned with following a structured plan. Answering 3 to 5 shows a tendency toward outcome bias. Advice for Accumulators Aggressive clients are generally the most difficult clients to advise, particularly those who have experienced losses. Because they like to control or at least get deeply involved in the details of investment decision making, they tend to eschew advice that might keep their risk tolerance in check. And they are emotionally charged and optimistic that their investments will do well, even if that optimism is irrational. Some Accumulators need to be monitored for excess spending, which, when out of control, can inhibit performance of a long-term portfolio. The best approach to dealing with these clients is to take control of the situation. If the advisor lets the Accumulator client dictate the terms of the advisory engagement, they will always be at the mercy of the client's emotionally driven decision making and the result will likely be an unhappy client and an unhappy advisor. Advisors to Accumulators need to demonstrate the impact financial decisions have on family members, lifestyle, or the family legacy. If these advisors can prove to the client that they have the ability help the client to make sound long-term decisions, they will likely see their Accumulatorclients fall into step and be better clients that are easier to advise. 12.7SUMMARY  Each BIT has biases that are associated with it, which will be discussed extensively in the next section.  BITs are not intended to be “absolutes” but rather “guideposts.” 228 CU IDOL SELF LEARNING MATERIAL (SLM)

 Investors who have a high need for security (i.e., a low risk tolerance) do so because emotion is driving this behavior; they get emotional about losing money and get uneasy during times of stress or change.  highly aggressive investors are also emotionally charged people who adamantly want to accumulate assets  A quantitative approach is more effective with clients who are less emotional and tend to make cognitive errors.  Emotional clients tend to be more difficult clients to work with, and advisors who can recognize the type of client they are dealing with prior to making investment recommendations will be much better prepared to deal with irrational behavior when it arises.  Preservers are, as the name implies, passive investors who place a great deal of emphasis on financial security and preserving wealth rather than taking risk to grow wealth. Because they have gained wealth by not risking their own capital,  Preservers are “worriers” in that they obsess over short-term performance (losses) and are slow to make investment decisions.  Followers They often follow the lead of their friends and colleagues in investment decisions,  Followers want to be in the latest, most popular investments without regard to a long- term plan. One of the key challenges of working with Followers is that they often overestimate their risk tolerance.  Advisors need to be careful not to suggest too many “hot” investment ideas— Followers will likely want to do all of them.  In psychology, cognitions represent attitudes, emotions, beliefs, or values.  Advisors to Followers first and foremost need to recognize that Followers often overestimate their risk tolerance.  Risky trend-following behavior occurs in part because Followers don't like situations of ambiguity that may accompany the decision to enter an asset class when it is out of favor.  They also may convince themselves that they “knew it all along” when an investment idea goes their way, which also increases future risk-taking behavior.  Advisors need to handle Followers with care because they are likely to “say yes” to investment ideas that make sense to them, regardless of whether the advice is in their best long-term interest.  Independents are self- assured and “trust their instincts” when making investment decisions; however, when they do research on their own, they may be susceptible to acting on information that is available to them rather than getting corroboration from other sources.  The Accumulator is the most aggressive behavioral investor type 229 CU IDOL SELF LEARNING MATERIAL (SLM)

 Overconfidence is best described as unwarranted faith in one's own thoughts and abilities, which contains both cognitive and emotional elements.  Overconfidence manifests itself in investors’ overestimation of the quality of their judgment.  Aggressive clients are generally the most difficult clients to advise, particularly those who have experienced losses. 12.8KEYWORDS  Recency bias is a predisposition for investors to recall and emphasize recent events and/or observations.  Framing bias is the tendency of Followers to respond to situations differently based on the context in which a choice is presented (framed).  An Independent is an active investor with medium-to-high risk tolerance who is strong-willed and an independently minded thinker.  Overconfidence is best described as unwarranted faith in one's own thoughts and abilities, which contains both cognitive and emotional elements  Accumulator is the most aggressive behavioral investor type.  Followers are typically passive investors who do not have their own ideas about investing. 12.9 LEARNING ACTIVITY 1. using the questionnaire given in the notes, prepare a questionnaire for surveying among your relatives to classify them into one of the 4 types of investors we have studied ___________________________________________________________________________ ___________________________________________________________________________ 2. Identify each one of investors and make a note of the advice you would give them ___________________________________________________________________________ ___________________________________________________________________________ 12.10UNIT QUESTIONS A. Descriptive Questions Short Questions 1. What advice would you give an accumulator? 2. Explain Cognitive dissonance bias ? 3. What is the main bias of the Preserver BIT? 230 CU IDOL SELF LEARNING MATERIAL (SLM)

4. What is the main bias of the Independent BIT? 5. What is the main bias of the Accumulator BIT? 6. What is the main bias of the Follower BIT? Long Questions 1. Explain all the biases of Preserver BIT 2. Explain the Accumulator BIT in depth 3. Which of the 4 BITs are you; explain your BIT type’s biases in detail? 4. Explain the Biases that are experienced by the Follower type of Investor personality. What is the advice you can give them. 5. Independents are less inclined to listen to the advice of their advisors. Why? How should they be tackled? B.Multiple Choice Questions 1. ______ place a great deal of emphasis on financial security and preserving wealth rather than taking risk to grow wealth. a. Followers b. Accumulators c. Independents d. Preservers 2. Some Preservers are______ in that they obsess over short-term performance (losses) and are slow to make investment decisions a. reckless b. worriers c. goalless d. mindless 3. ______ are typically passive investors who do not have their own ideas about investing. a. Preservers b. Accumulators c. Followers d. Independents 4. One of the key challenges of working with Followers is that they often ______ their risk tolerance. a. underestimate b. avoid c. are not clear about 231 CU IDOL SELF LEARNING MATERIAL (SLM)

d. overestimate 5. Advisors need to be careful not to suggest too many ______ investment ideas— Followers will likely want to do all of them a. cold b. hot c. tip based d. loose Answer 1-d, 2-b, 3-c, 4-d, 5-b 12.11 REFERENCES  M. Barnewall, “Psychological Characteristics of the Individual Investor,” in Asset Allocation for the Individual Investor, ed. William Droms (Charlottesville, VA: Institute of Chartered Financial Analysts, 1987).  Thomas Bailard, David Biehl, and Ronald Kaiser, Personal Money Management, 5th ed. (Chicago: Science Research Associates, 1986).  M. Barnewall, “Psychological Characteristics,” see note 2. 232 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT 13 - SEGMENTING INVESTORS: CLUSTER AND DISCRIMINANT ANALYTICS OF INVESTORS BEHAVIOUR IN INDIAN FINANCIAL MARKETS. STRUCTURE 13.0Learning objective 13.1Introduction 13.2 What is a Segment? 13.3 What is Discriminant Analysis? 13.4 Multiple Discriminant Analysis 13.5 Securities Market 13.6 Investor sentiment, defined as the belief about future cash flows and investment 13.7 Cluster Analysis in Finance 13.8 Summary 13.9 Keywords 13.10 Learning activity 13.11Unit End Questions 13.12 References 13.0LEARNING OBJECTIVE After studying this unit, you will be able to:  Define what is a Segment  Identify the various catergories of investors based on numerous criteria  Understand how cluster analysis is applied by investors in portfolio analysis  Ennumerate the different attributes used to classify the investors  Apply the above to identify investor approach in routine life. 13.1 INTRODUCTION The concept of Segmentation comes from Marketing. We apply the same concept to finance in order to categorise prospective investors into various categories depending on different qualitative attributes. In segmentation, the market is divided into various types of divisions based on the characteristics of the target. Similarly in behavioural finance, we try to divide 233 CU IDOL SELF LEARNING MATERIAL (SLM)

our prospective investors into various categories depending on various factors. One important attribute to consider in finance is the risk bearing capability of the investor. In this chapter we will understand the concept of segmentation and the application of the concepts of distriminant analysis and clustering to investing and investor behaviour. 13.2 WHAT IS A SEGMENT A division or subset of a business'operations,especially in largecorporations. For a division to be considered a segment, it mustdirectlyearnrevenueforthecompany.Forexample, a heavilydiversifiedcorporationmayhaveonesegmentdedicated to telecommunications,another to manufacturing,and a third to energy. It is alsoknownsimply as a segment.Internally,eachsegment'sexpensesandrevenuesareaccountedforseparately. 13.3 WHAT IS DISCRIMINANT ANALYSIS Discriminant analysis is used to analyze different data sets so that new items can be classified. It’s a popular statistical tool because it has widespread use across different industries, and businesses can analyze specific problems by determining what independent variables have the most significant outcome on a dependent variable. The results are often very reliable as you can define an issue or question, locate the discriminant function and discover its significance, and interpret the results and gauge the validity.  Linear: Linear discriminant analysis is often used in machine learning applications and pattern classification. It’s also commonly used for dimensionality reduction, which minimizes the number of variables that are being considered.  Quadratic: Similar to linear discrimination analysis, but with observations made from the normal distribution, with each class having its own covariant matrix. In machine learning, it separates the measurements for two or more event categories.  Canonical: Measures the connection or correlation between two unique sets of variables, which are split into different groups (X and Y), so that the relationship between the two variables can be further explored.  Gaussian: Also called normal distribution, this method involves a distribution that is dependent on the mean and standard deviation of a data set. Data scientists often use this when working on artificial intelligence (AI) projects. 13.4 MULTIPLE DISCRIMINANT ANALYSIS The term multiple discriminant analysis (MDA) refers to a statistical technique used by financial planners, investment advisors, and analysts to evaluate potential investments when many variables are at stake. MDA allows financial professionals the viability of investing in various market securities by studying different factors or variables, such as volatility. This is 234 CU IDOL SELF LEARNING MATERIAL (SLM)

a branch of discriminant analysis, which is used by researchers and statisticians who make classifications of individuals and data based on different variables Multiple discriminant analysis is a technique that distinguishes datasets from each other based on the characteristics observed by a professional.2it is used in finance to compress the variance between securities while screening for several variables. By using the MDA technique, financial professionals reduce the differences between certain variables so they can be classified into a number of larger groups and then compared to another variable. In most cases, professionals who use MDA often try to group data into at least three, if not more, different groups.3 An analyst who is considering a number of stocks may use multiple discriminant analysis as a tool to focus on the data points that are the most important. This simplifies the other differences among the stocks without totally dismissing them. For instance, an analyst who wants to select securities based on values that measure volatility and historical consistency may use MDA in order to factor out other variables such as price. The main reason that professionals use this technique is to develop Markowitz efficient sets These investment portfolios are developed based on returns that are maximized for a certain level of risk. These were named after economist Harry Markowitz, who is also considered to be the father of modern portfolio theory (MPT). Special Considerations As noted above, multiple discriminant analysis is related to discriminant analysis, which is commonly used by statisticians and other researchers. MDA is also known, at least to statisticians, as canonical variates analysis or canonical discriminant analysis. It is a type of discriminant analysis, which is widely used by researchers analyzing data in many fields. Discriminant analysis helps researchers and statisticians classify different data sets by setting a rule or selecting a value that will provide the most meaningful separation. Several studies have been conducted in regard to categorising investors into various subgroups, based on financial knowledge, allocation strategies and personality, (Bailard et al. 1986; Gunnarsson and Wahlund 1997; Harrison 1994; Pompian 2012; Waneryd 2001; Wood and Zaichkowsky 2004) instead of treating them as a homogeneous and wholly rational unit, as done by MPT. Keller and Siegrist (2006) divided investors into 'Safe Players', 'Open Books', 'Money Dummies' and 'Risk Seekers', by virtue of their risk attitudes and perceptions toward securities, the stock market and gambling. Age is also found to be a causal factor in risk aversion (Riley and Chow 1992), along with one's occupation, wherein corporate executives and lawyers are found to be more risk averse (Barnewall 1987) and even the Myers– Briggs Type Indicator (MBTI) has been used to segment investors (Filbeck et al. 2005). Gender yields differences as well, with female investors exhibiting more risk aversion 235 CU IDOL SELF LEARNING MATERIAL (SLM)

than male investors (Barsky et al. 1997). Unlike classical finance, behavioural finance does not view investors as having the same standardised and rational goals, instead construing the former as unique segments with varying and sometimes opposing aims. 13.5 SECURITIES MARKETS The capstone of capital markets research theorises that it is not possible to consistently achieve above average market returns, given the current information. This is more formally defined as the Efficient Market Hypothesis (EMH), which has three major forms, 'weak', 'semi-strong' and 'strong'. This theory, developed in the 1960s (Fama 1965; Samuelson 1965), state that when faced with new information some investors may underreact and others may overreact with an overall random pattern that conforms to a normal distribution. This results in a situation wherein market prices cannot be reliably exploited to make abnormal profits. Some of the classical finance thread espouses the maxim that the best established fact in eco- nomics is the efficiency of securities markets (Jensen 1978). However, many feel, especially in the aftermath of the recent financial crisis, that the blind trust in such a framework (Volcker 2011) along with deregulation, such as the Gramm–Leach– Biley Act has led to the downward spiral of the global economy. Brusquely put by Shiller (1981), the failure of the efficient market model is so dramatic, that it would seem impossible to attribute the failure to such things as data errors, price index problems or changes in tax laws. Behavioural finance sees the flaws in financial markets as due to cognitive biases and human error, as outlined below. HighRiskBearer ModerateRisk LowRiskBearer Income Bearer H CanoptforHighBetastocksas Can go for thoseStronglyAdvisedBlue Chip i wellassomepennystockscan shareswhoseIntrinsic Companieswithlongterminvestment g alsobepresentin ValueisatparwiththeM horizon. h theirbaskets. arketValue Canoptforrisk-adjustedlowreturn They can also makeCanoptforthoseshares shares. e moveinIntra-dayTrading withunexpected r fluctuationinvalues. I n c o 236 CU IDOL SELF LEARNING MATERIAL (SLM)

m e G r o u p M Can be advised to Can opt for Canoptforthoseshares e increasetheir participation thoseshares wherefluctuationinvaluesis d in HighBetaStocks. Can wherefluctua minimal. Would invest in i also be benefited tioninvaluesiswithin thoseshares where liquiditywhile u fromhaving short term tolerable selling is not anissue or else m holdingin equitymarket. range.Wouldinvesti choosingshareswithhightradingvo I nthoseshareswhereli lumes. n quiditywhilesellingi c snotanissueorelsech o oosingshares with m mediumtradingvolu e mes. G r o u p L Since they are from low income group and their education level as well o asunderstanding of the equity market is very less in spite of the fact of w theirwillingness to have the test of equity market in their investment portfolio. e Thiscompelsthemtogowithinvestmentinthestockmarketwithsomeexpert advice.Thus r Mutual Fund willbetheirobvious choiceof majorityof them. I n 237 CU IDOL SELF LEARNING MATERIAL (SLM)

c o m e G r o u p Age 18- Asinthisagegroupthenum Midcap/largecapissu Largecap/bluechipcompanies 35 berofdependentsisminima ggested aresuggested based landavailablesurplusmone theirlowerriskbearingcapacity. yforinvestment is high, so theybehaveashighincome groupwithhighriskbearing capacity.Soinvestmentsho uldbeinmid-cap/small- capsharesas well as in those shareswhich are presently availableunderpricedwith potential of high growth in coming future. 238 CU IDOL SELF LEARNING MATERIAL (SLM)

36- As in this age group Asinthisagegrouppeoplearehighly 53 peoplearehighlyburdened burdenedwiththeirsocialliabilities andtheircompulsionofTaxLiabiliti withtheirsocialliabilitiesa esledthemtoinvestinstockmarkett ndtheircompulsionofTaxL hroughtaxsavingMutual iabilitiesledthemtoinvesti nstockmarketthrough tax fund saving Mutualfund 54- Usuallypeopleareoverburdenedwiththeirsocialresponsibilitiesandmajority of them 71 from service class found himself with surplus money at theage of sixty with his retirement benefits. At this stage a person stands withsurplusmoney aswellasenough time tospend in the stock market.Thesefactsconvert them as new investorsin the stockmarket. Firstly as an infant in the stock market it is important for the participant thatthey should be well-informed or they must be updated with the news as we allknew that market discounts every news. This is also in one of the tenets ofDOWTheory.Ifthey don’t have financialexpertise they may take someauthenticpaid advices from experts even. Secondlyriskprofilingofthecustomersisagainavitalpartwhichmustbe taken care off before making an investment accordingly in small-cap, mid- capandstrongcapcompanies. 72& Keepinginmindabouttheirlifeexpectancytheyshouldstudytheirinvestment horizon Abo which should not be alongterm. ve Iftheyareinasoundfinancialpositionastheyarefreefromtheirdependent’stheycanalsopar ticipateinintra-daytradingformakingadventurousmove. Theycomeunderhighrisk bearerwithshorttermhorizon. 239 CU IDOL SELF LEARNING MATERIAL (SLM)

If they wish to gift their investments to their next generations or to their grandchildren’sthentheycanchoosesharesofthecompanieshavinggoodfundamentalsor elsecompanieswhichhavegoodfutureprospects.Companieswhoseintrinsic valueis less than the market value. If they are low risk bearer then they should invest in companies with soundfundamentalsor thecompanies which isless Betasensitive. Hereagaintheinvestorsshouldfocusonthosestockswhichdonothave liquidityissues as their time horizon is short. EducationalQualification Gra Graduates canbeclassifiedintotwogroups; duat Newly Graduates who are beginners in earning as well as new in this e financialmarket they need to study the market first so that they can be updated with themarket news. Risk profiling is again important so that to select the stockswherethe investment canmade. Graduateswhoarewellinformedintheequitymarket-Basedontheirrisk appetite they should made investments in small-cap, mid-cap and large capsharesaccordingly. P BeingPostGraduatedoesnotmakeanynotabledifferenceasfarasinvestmentinthestockma o rketisconcerned Itisimportanttohaveinclination towards making investment in the st share market which will createan urge to get more and more information about this G investment avenue. Thisis vital part missing with the Indian investors which resist r them in a makinginvestmentinstockmarketdirectlyandthustheyoptfortraditionalinvestment d avenues ending with negative inflation adjusted returns. Lastly it u ispertinenttomentionherethatstockmarkethasnotmuchtodowitheducationaldegreesrath at erheremattersin-depthknowledgeandtimespentin themarket. e Pro Iftheyarenotequitymarketprofessionalsthentheyareleftwithverylittletimetospendinthe fess market.Theyareoverinvolvedintheirownprofession ion butavailablewithenoughinvestiblemoneywithfairriskbearingcapacity. all 240 CU IDOL SELF LEARNING MATERIAL (SLM)

Due to this condition more often they fall prey to agents who mis-sell theirfinancial products. So these professional should take help from some financialexpertswhohelpthemtochoosethosestockswhichsuitsthemaccordingto theirriskappetite. No.Family Members Belo Sincenumberofdependent Their Since risk appetite islow so it is w3 s is less so as occupa advisabletostrictlyoptforscrip’swi theliabilities,theymayhav ncyshould more in thstableBetaCo-Efficient. eexposureintohighBetasto mid Opting for Blue chipCompaniesorlargecapshareswi cks. capsharesandthesha llbea They may reswithBetashouldb Rationaldecision. emoderate,toavoidv alsoparticipateinsmall cap olatilitysoastherisk/ returnadjustments. scrips. 3-5 They can optfor Againforthisgroups Againforthisgroupshareswithless midcaporsmallcapstockss hareswithlessbetase betasensitivity isadvisable. incetheyaregoodintakingr nsitivityisadvisable. isk. And it is clearly statedthathighrisksareasso ciatedwithhigh returns. 6-8 Here number of dependents are more so to meet all social liabilities expenseswill be more thus seeing the investible surplus which not be enough, it isadvisable to choose thosemid cap shares which has good future prospects orlarge cap shares keeping long term investment objectives. As the number ofdependentsarenotablymoresothefamilymaysometimefallinurgentneed ofmoneysotheyshould investin such stockswhereliquidityis not anissue. 9&A Sincenumberofdependentsismoresoas the liabilitiesitisadvisabletomake bove investmentbasedonexpertadvice.Theyshouldoptthisinvestmentavenueforlonginvestmen tobjectives.TheyshouldavoidtheirparticipationinIntra- 241 CU IDOL SELF LEARNING MATERIAL (SLM)

Table:13.1.Strategiestostretchthe Segment wise Depthof Investment 13.6 INVESTOR SENTIMENT, DEFINED AS THE BELIEF ABOUT FUTURE CASH FLOWS AND INVESTMENT Risks that are not justified by the facts available (Baker and Wurgler 2007), is one of the central tenets of behavioural finance. This phenomenon proposes to explain sudden swings in the markets, for example, the rise and fall of internet stocks in the 1990s (Baker and Wurgler 2013). Baker and Wurgler (2007) have shown that it is possible to measure investor sentiment, creating indices of the latter for the global markets and find that it plays a critical role in international market volatility (Baker et al. 2012). Investors irrationally hold on to losing stocks, known as the disposition effect, possibly to avoid confronting their incorrect investment decisions (Hirshleifer 2001; Shefrin and Statman 1985). This effect can cause under reaction to news, leading to predictable returns and post- announcement price drift (Frazzini 2006). The dis- position effect is highest in non- professional and low-income investors (Dhar and Zhu 2002), reflecting that investors cannot be thought of a single and rational unit. There exists the momentum effect, where past winners almost always outperform past losers (Jegadeesh and Titman 2001b). Stocks that perform the best or worst over a 3–12 months period tend to continue to perform well or poorly respectively over the subsequent 3–12 months (Jegadeesh and Titman 1993). Under the EMH, any predictable patterns in return should be swiftly eliminated. However, momentum profits have been found in most major developed markets in the world, excluding Japan (Jegadeesh and Titman 2001a). Whilst returns appear to exhibit momentum in the short–medium run, they tend to revert to fundamentals in the long run (Hong and Stein 1999). Specifically concerning the internet boom, investor sentiment played a major role in the stock prices of firms. Those that dropped the 'dotcom' naming conventions to dissociate themselves from the internet sector after the price crash saw a positive announcement effect (Cooper et al. 2005). It thus appears that the effect of investor sentiment is so severe that it can cause price variations even from manifestations as trite as company name changes. Research has shown that certain times of the year, in this case, January, predicate certain feelings in stock market investors, with the market performing well overall and smaller stocks out-performing larger ones (Anderson et al. 2007; Keim 1983; Rozeff and Kinney 1976). January is viewed to be one month of renewed optimism, with investors, regardless of their failure in that year, concluding that they can correct their mistakes on the next attempt, resulting in a perpetual January Effect cycle (Ciccone 2011; Polivy and Herman 2002). There is also evidence that it is the risk premium and not the risk itself that is higher in January, perhaps indicating that the January effect is due to higher compensation for risk in that 242 CU IDOL SELF LEARNING MATERIAL (SLM)

month, rather than due to just risk (Sun and Tong 2010). The fact that disappointed investors never seem to learn, and mitigate that the cycle is testament to their irrationality, running against the grain of the ever rational investors in the MPT sphere. Recent findings also indicate that the January effect is weakening (Jones and Pomorski 2002), but it is unclear whether this means that investors are becoming more rational, or some other effect is at play. Notwithstanding monthly effects, even different days of the week predicate varying effects in the market, with the highest returns on Wednesday, and the lowest on Monday (Berument and Kiymaz 2001) and with the highest selling activity on the present day (Abraham and Ikenberry 1994). Also, Friday's returns are lower when Saturday is a trading day (Keim and Stambaugh 1983), with little reasonable explanation (Gibbons and Hess 1981), and the last trading day before holiday’s exhibits abnormally high returns (Ariel 1990; Kim and Park 1994). Returns from the May–October period are lower than the remainder of the year, known as the 'Halloween Indicator' and are often negative, but no explanation has been posited for this effect thus far (Bouman and Jacobsen 2002). Even lunar phases have an effect on the stock market, with lower returns on days around a full moon than compared to those around a new moon (Floros and Tan 2013; Yuan et al. 2006). This has been observed for all the major U.S. stock indexes, and several other countries, but with no effects on return volatility or trading volume (Dichev and Janes 2003). Such effects are impossible to reconcile with rational means of price setting, and are clearly in opposition to all forms of the efficient markets hypothesis. The weather affects markets as well; sunshine is positively correlated with stock returns (Dowling and Lucey 2005; Hirshleifer and Shumway 2003). The weather in New York City is has a long history of significant correlation with major stock indexes (Saunders 1993), completely unjustifiable by the MPT. Geomagnetic storms, during their recovery phase, also appear to negatively affect several inter- national stock indices, with a more pronounced effect for smaller capitalization stocks, perhaps due to the profound effect on people's moods and that small cap- italisation stocks are generally held by individuals, who are likely to be more affected by mood than institutional investors (Krivelyova and Robotti 2003). Sports results also affect market returns, with losses in international soccer matches having negative effects on global stock markets (Edmans et al. 2007). There also exists the Super Bowl Stock Market Predictor, which if used as an investment strategy, over the 1967–1988 period, yields higher returns than a buy and hold strategy over the same period, clearly inconsistent with the efficient markets hypothesis (Krueger and Kennedy 1990). The Super Bowl also has other effects, with abnormal buying activity amongst small traders for recognised Super Bowl advertisers' shares (Fehle et al. 2005). In relation to stock market data, it is found that despite investors acquiring useful information, they somehow misinterpret it and underperform the market (Barber and Odean 2000; Odean 1999). The type of audience to which the information is presented, is also 243 CU IDOL SELF LEARNING MATERIAL (SLM)

significant. Unsophisticated investorsassess a firm's earnings performance to be higher when presented with more positive pro-forma earnings prior to Generally Accepted Accounting Principles (GAAP) earnings, than com- pared to when only shown GAAP earnings. Sophisticated investors, however, were not affected by the order of presentation or the information presented (Elliot 2006; Victoravich 2010). In the perfect markets imagined by Miller and Modigliani, dividend policy is inconsequential to a firm's value, and stockholders should complain if a firm pays tax dividends, given that dividends are taxed at a higher rate than capital gains. However, stockholders often do the opposite, complaining when dividends are cut (Thaler and Bondt 1995). This illogical mode of thought may be because investors psychologically resist utilizing their capital and view dividends as a separate gain when the stock price rises, and a fall back for price drops (Shefrin and Statman 1984). Repeatedly, the axioms of conventional finance have been challenged by contemporary financial phenomena. Fashions and fads also affect securities prices, especially since investors are influenced by their social environment and are pressured to conform (Aronson 1991). For example, a downtrend may occur during a financial crisis, when investors irrationally decide to unload their holdings, as per the actions of their neighbour, or when a market guru prescribes the latest stock or investment heuristic. Investors face an uphill task when it comes to selecting securities, given the staggering amounts available. As most investors do not have access to a retail broker to suggest what they should purchase, they end up buying what is discussed in the media, those which have performed unusually well or poorly (Odean 1999). The above phenomena could be explained by herding which may also have ledto bank panics, when depositors run on banks, seeing other depositors proceeding as such. Several herding models exist (Brunnermeier 2001), and there are higher levels of herding in small stocks (Wermers 1999). Furthermore, stocks bought by herds have higher returns than those sold by herds (Wermers 1999). Analysts release earnings forecasts that do not vary much from prior expectations, with a tendency to report forecasts similar to those released by other analysts, although their private information may justify differing forecasts (Trueman 1994). Age also appears to play a part, as younger analysts are more prone to herding than their older contemporaries, with the former forecasting closer to the consensus forecast (Hong et al. 2000). It is observed that the twin stock of multinational companies, with nearly identical cash flows, move more like the markets where they trade most intensively than otherwise expected (Froot and Dabora 1999). This is in opposition to the classical finance paradigm that predicts that an asset's price is unaffected by its trade location. Although behavioural finance is unable to resolve all the conundrums that exist within finance, it has done an admirable job of attempting to explain some of the ever irrational behaviour of investors, by passing every boom and bust. Whilst trading frequency seems to eliminate some market anomalies (Dhar and Zhu 2002; List 2003), perennial issues such as 244 CU IDOL SELF LEARNING MATERIAL (SLM)

the Closed-End Fund Puzzle and Equity Premium Puzzle (Mehra and Prescott 1985) are still unresolved, although insights have been provided by the mechanisms of behavioral finance (Bernartzi and Thaler 1995; Lee et al. 1991). The overarching aim of behavioural finance is then not to replace the methods that compose classical finance, but to explain market anomalies, and complement existing frameworks that are already in place. As a whole, behavioral finance explores how investors act in given situations,and attempts to explain market anomalies. However, the means by which one pursues such goals is yet unexplored. Delving into the means of goal pursuit is necessary to understand how and why participants move toward these goals. Without comprehending these means, the market effects observed in behavioural finance will only be observed, never truly understood. Failing to grasp the means and underlying motivations of these behaviours, policies implemented to prevent future financial crises which are unlikely to be effective. Regulatory focus theory, as described in the following section, is put forth to explain the relationship between one's motivations and the associated goal.  The Gramm-Leach-Biley Act repealed part of the Glass-Steagall Act of 1933, removing market barriers among banks, securities and insurance companies that prohibited any one institution from acting as both an investment bank, commercial bank or insurance company. With the Gramm-Leach-Biley Act, consolidation was allowed. Thus, people were then able to invest and save at the same financial institution  The disposition effect is the tendency of investors to sell shares whose price has increased, while keeping those that have dropped in value  The post-announcement price drift is the tendency for a stock's cumulative abnormal returns to move in a direction that will yield results that are higher or lower than analysts' predictions  The Super Bowl Stock Market Predictor indicates that, if the Super Bowl is won by a team from the old National Football League, the stock market wills finish the year higher than it began (Stovall, 1989). However, if the game is won by a team from the old American Football League, the market will finish lower than it began  Sophisticated investors are those who possess stock market investment experience, and knowledge acquired through this experience and other practices, such as, completion of finance and accounting courses and certifications  Herding can be defined as behaviour patterns that are correlated across individuals  Since closed-end funds are exchange traded, their prices are different from the net asset value, defined as the closed-end fund puzzle  The equity premium puzzle stems from the fact that the demand for government bonds is high, despite the fact that they return less than stocks, and why there is even a demand at all 245 CU IDOL SELF LEARNING MATERIAL (SLM)

13.7 CLUSTER ANALYSIS IN FINANCE Cluster analysis is a technique used to group sets of objects that share similar characteristics. It is common in statistics. Investors will use cluster analysis to develop a cluster trading approach that helps them build a diversified portfolio. Stocks that exhibit high correlations in returns fall into one basket, those slightly less correlated in another, and so on, until each stock is placed into a category. If done correctly, the different clusters will exhibit minimal correlation from one another. This way investors gain all the virtues of diversification: reduced downside losses, capital preservation, and the ability to make riskier trades without adding to the total risk. Diversification remains one of the central tenants of investing and cluster analysis is just one channel to achieving it. Understanding Cluster Analysis Cluster analysis enables investors to eliminate overlap in their portfolio by identifying securities with related returns. For example, a portfolio of only technology stocks may seem safe and diversified on the surface, but when an event like the Dotcom Bubble strikes, the entire portfolio is vulnerable to significant losses. Buying and clustering assets that fit different market segments is crucial to increase diversification and protect against such systemic risks. Stock Selection and Trading Based On Cluster Analysis The technique can also uncover certain categories of stocks like cyclical and growth stocks. These specific strategies fall under the smart beta or factor investing umbrella. They attempt to capture better risk-adjusted returns from specific risk premiums like minimum volatility, growth, and momentum. In some way, smart beta or factor investing embodies the concepts of grouping and categorization preached by cluster analysis. The logic of clustering on a single common behavior mirrors the basic methodology behind factor investing, which identifies stocks susceptible to similar systemic risks and share similar characteristics. It's not always the case that assets in a cluster live in the same industry. Oftentimes, clusters hold stocks from multiple industries like technology and financials. Criticism of Cluster Analysis An obvious drawback to cluster analysis is the level of overlap between clusters. Clusters close in distance, meaning a high correlation in returns; often share some similar risk factors. Thus, a down day in one cluster could translate to an equally weak performance in another cluster. For this reason, investors should find and cluster stocks with a large distance between them. That way, the clusters are impacted by different market factors. 246 CU IDOL SELF LEARNING MATERIAL (SLM)

That said, broad market pullbacks like the 2008 Recession will throttle the entire portfolio regardless of its construction. Even the most diversified clusters would have trouble withstanding recessionary headwinds. Here, the best clustering can do is minimize the extreme downside losses. 13.8SUMMARY  A Segment is a division or subset of a business'operations,especially in large corporations.  Discriminant analysis is used to analyze different data sets so that new items can be classified.  For a division to be considered a segment, it mustdirectly earn revenue forthecompany.  The term multiple discriminant analysis (MDA) refers to a statistical technique used by financial planners, investment advisors, and analysts to evaluate potential investments when many variables are at stake.  MDA allows financial professionals the viability of investing in various market securities by studying different factors or variables, such as volatility.  This is a branch of discriminant analysis, which is used by researchers and statisticians who make classifications of individuals and data based on different variables  Multiple discriminant analysis is a technique that distinguishes datasets from each other based on the characteristics observed by a professional.  It is used in finance to compress the variance between securities while screening for several variables.  By using the MDA technique, financial professionals reduce the differences between certain variables so they can be classified into a number of larger groups and then compared to another variable.  An analyst who is considering a number of stocks may use multiple discriminant analysis as a tool to focus on the data points that are the most important. This simplifies the other differences among the stocks without totally dismissing them.  Discriminant analysis helps researchers and statisticians classify different data sets by setting a rule or selecting a value that will provide the most meaningful separation.  Keller and Siegrist (2006) divided investors into 'Safe Players', 'Open Books', 'Money Dummies' and 'Risk Seekers', by virtue of their risk attitudes and perceptions toward securities, the stock market and gambling.  Corporate executives and lawyers are found to be more risk averse (Barnewall 1987) and even the Myers– Briggs Type Indicator (MBTI) has been used to segment investors (Filbeck et al. Female investors exhibiting more risk aversion than male investors (Barsky et al. 1997) 247 CU IDOL SELF LEARNING MATERIAL (SLM)

 Risks that are not justified by the facts available (Baker and Wurgler 2007), is one of the central tenets of behavioural finance.  There exists the momentum effect, where past winners almost always outperform past losers (Jegadeesh and Titman 2001b).  Research has shown that certain times of the year, in this case, January, predicate certain feelings in stock market investors, with the market performing well overall and smaller stocks out-performing larger ones  Even lunar phases have an effect on the stock market, with lower returns on days around a full moon than compared to those around a new moon  Cluster analysis is a technique used to group sets of objects that share similar characteristics. It is common in statistics. Investors will use cluster analysis to develop a cluster trading approach that helps them build a diversified portfolio. Stocks that exhibit high correlations in returns fall into one basket, those slightly less correlated in another, and so on, until each stock is placed into a category.  Cluster analysis enables investors to eliminate overlap in their portfolio by identifying securities with related returns. For example, a portfolio of only technology stocks may seem safe and diversified on the surface, but when an event like the Dotcom Bubble strikes, the entire portfolio is vulnerable to significant losses. Buying and clustering assets that fit different market segments is crucial to increase diversification and protect against such systemic risks.  The technique can also uncover certain categories of stocks like cyclical and growth stocks. These specific strategies fall under the smart beta or factor investing umbrella. They attempt to capture better risk-adjusted returns from specific risk premiums like minimum volatility, growth, and momentum. . 13.9 KEYWORDS  A Segment is a division or subset of a business'operations,especially in large corporations.  Discriminant analysis is used to analyze different data sets so that new items can be classified.  MBTI – Myerrs Briggs Type Indicator  Cluster analysis is a technique used to group sets of objects that share similar characteristics.  Discriminant analysis helps researchers and statisticians classify different data sets by setting a rule or selecting a value that will provide the most meaningful separation. 13.10 LEARNING ACTIVITY 248 CU IDOL SELF LEARNING MATERIAL (SLM)

1. Find out any one study on determining the various clusters of investors ___________________________________________________________________________ ___________________________________________________________________________ 2. Is the current stock market exhibiting Momentum effect? List out 5 reasons why for your answer? ___________________________________________________________________________ ___________________________________________________________________________ 13.11 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. What is discriminant Analysis? 2. Explain Cluster Analysis in short. 3. What is MDA? 4. Explain the concept of stock selection based on cluster analysis 5. Explain how fashions and fads affect security prices Long Questions 1. Explain Cluster Analysis. Its usage in investment and stock selection? Explain its advantages and disadvantages. 2. How do researchers classify various investors segments? 3. What are the various parameters on which Investors can be segmented? 4. Describe the behaviour of investors based on their occupation 5. How do people in various age groups behave? B. Multiple Choice Questions 1. In relation to stock market data, it is found that despite investors acquiring useful information, they somehow misinterpret it and ______________the market. a. beat b. over perform c. underperform d. fail 2. ________ analysis is a technique used to group sets of objects that share similar 249 characteristics. a. Determinant CU IDOL SELF LEARNING MATERIAL (SLM)

b. Cluster c. MDA d. Return 3. ________ can be defined as behaviour patterns that are correlated across individuals a. Herding b. Taming c. Building d. GroupThink 4. The term ________________ refers to a statistical technique used by financial planners, investment advisors, and analysts to evaluate potential investments when many variables are at stake a. Discriminant Analysis b. Multiple Discriminant Analysis c. Cluster Analysis d. Segmentation 5. ___________ is viewed to be one month of renewed optimism, with investors, regardless of their failure in that year, concluding that they can correct their mistakes on the next attempt. a. April b. October c. December d. January Answer 250 1-c, 2-b, 3-a, 4-a, 5-d 13.12 REFERENCES  https://financial-dictionary.thefreedictionary.com/segmentation  https://ebrary.net/15928/business_finance/investor_segmentation CU IDOL SELF LEARNING MATERIAL (SLM)