Investor Profiling and Investment Planning: An Empirical Study

Saptarshi Purkayastha*

Risk tolerance, a person's attitude towards accepting risk, is an important concept that has implications for both financial service providers and consumers. This paper attempts to characterize and profile the individual investor in order to determine whether the variablesage, occupation, designation, income and dependants impact the risk appetite of an investor. The paper draws on data collected from the clients of an international bank operating in India. The data are analyzed in two stages. In the first stage, it analyzes whether demographics impact the risk appetite of an investor or not. In the second stage, it analyzes as to where people having specific demographics and risk appetite invest their money in reality. Some of the key findings are that age, salary and designation do impact the risk appetite of an investor. However, in reality, investors tend to invest in average risk mutual funds, irrespective of their demographics and risk tolerance. The findings provide some opportunities for purveyors of financial services to be selective in their approach to various groups of individual investors.

Introduction Risk tolerance, a persons attitude towards accepting risk, is an important concept that has implications for both financial service providers and consumers. For the latter, risk tolerance is one factor which may determine the appropriate composition of assets in a portfolio, which is optimal in terms of risk and return relative to the needs of the individual. Risk is often defined as portfolio volatility, or the fluctuation in the value of assets over time. At a personal level, risk can mean the chance that one will not achieve ones goals or the risk of losing ones savings. Understanding tolerance for risk, which differs for each investor, is a key to choosing an investment program. The tolerance for risk is a very personal characteristic that may be difficult to determine and may change over time. Despite its importance in the financial services industry, there remain some unresolved questions with respect to the determinants of risk tolerance. Although a number of factors have been proposed and tested, a brief survey of the results reveal a distinct lack of consensus. First, it is generally thought that risk tolerance decreases with age (Wallach and Kogan, 1961; Mclnish, 1982; Morin and Suarez, 1983; and Palsson, 1996), although this relationship may not
* Faculty, The Icfai Business School, Hyderabad, India. E-mail: spurkayastha1@gmail.com
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Investor Profiling Investment Planning: An Empirical Study 2008 The Icfai and University Press. All Rights Reserved.

necessarily be linear (Riley and Chow, 1992; and Bajtelsmit and VanDerhai, 1997). Investment managers use this input (age) as a measure of the time remaining until a clients financial assets are needed to meet goals and objectives. In addition to being used as a proxy for time, investment managers also use age as a measure of someones ability to recoup financial losses. Income and wealth are two related factors that are hypothesized to exert a positive relationship on the preferred level of risk (Lee and Hanna, 1991; Riley and Chow, 1992; and Schooley and Worden, 1996). High-income investors can tolerate some loss better than the low income investor. This is primarily because high income investors can easily contribute additional investment capital even if they sustain any losses. Investment managers assume that self-employment status automatically leads to higher levels of risk-taking. Self-employed individuals are likely to choose riskier investments and accept increased investment volatility as compared to people who work for others for a straight salary (Meyer et al., 1961; Grey and Gordon, 1978; and MacCrimmon and Wehrung, 1986). Investigation of the investment decisions made by married individuals presents a unique challenge to researchers; this is so because they have the responsibilities of their children as well. The available evidence suggests that single investors are more risk-tolerant (Roszkowski et al., 1993), although some researchers have failed to identify any significant relationship (Mclnish, 1982; Masters, 1989; and Haliassos and Bertaut, 1995). The purpose of the present study is to provide evidence as to the relationship between risk tolerance and general demographics. In addition to an analysis of the relationship between risk tolerance and general demographics, special attention has been given to find out whether investors do invest their money according to their risk appetite.

Contribution of this Research

This study provides a new insight into the present knowledge of financial planning by providing an insight as to where people of specific demographic attributes and risk appetite invest their money, and whether various portfolio management theories do really hold good in practical situations also. It is anticipated that this study would be useful to investment managers in the following ways. First, this research would contribute to the efficacy of using demographics in determining the risk appetite of an investor. Second, it will provide some opportunities for purveyor of financial services to be selective in their approach to various groups of individual investors.

Literature Review
The literature review includes two parts. The first part reviews the traditional method of investment planning and also the relevant researches that have examined the relationship between demographics and risk tolerance. The second part examines how each demographic attribute affects the risk taking and
18 The Icfaian Journal of Management Research, Vol. VII, No. 12, 2008

investment decision of an individual that were identified in previous studies. We conclude the literature review with a summary.

Relationship Between Demographics and Risk Tolerance

The traditional financial planning models suggest an asset allocation strategy that focuses primarily on the age of the individual. Traditional method of asset allocation was based on keeping in mind the stage in the life-cycle of an individual. According to Bodie et al. (2002), the life-cycle of an individual is divided into four phases: accumulation phase, consolidation phase, spending phase and gifting phase. An individuals risk appetite and investment decisions changes over different phases, which is explained below. Accumulation Phase: Individuals in the early-to-middle years of their working careers are in the accumulation phase. They attempt to accumulate assets to satisfy fairly immediate needs (for example, a down payment for house) or long-term goals (childrens college education, retirement). Typically, their net worth is small, and debt may be heavy. As a result of their typically long investment time horizon and their earning ability, individuals in the accumulation phase are willing to make moderately high risk investments (equities) in the hopes of making above-average nominal returns over time. Consolidation Phase: Individuals in the consolidation phase are typically past the midpoint of their careers, have paid off much or all of their outstanding debts, and perhaps have paid or have the assets to pay their childrens college bills. Earnings exceed expenses, so the excess can be invested to provide for future retirement needs. The typical investment horizon is still long (20 to 30 years), so moderate risk investments remain attractive. Spending Phase: The spending phase typically begins when individuals retire. Because their earning years have concluded and they seek greater protection of their capital. At the same time, they balance their desire to preserve the nominal value of their savings due to inflation. Thus, although their overall portfolio may be less risky than in the consolidation phase, they still need to have some risky growth investments, such as common stocks, for inflation protection. Gifting Phase: The gifting phase is similar to, and may be concurrent with, the spending phase. In this stage, individuals believe that they have sufficient income and assets to cover their expenses while maintaining a reserve for uncertainties. Excess assets can provide financial assistance to relatives or friends or to establish charitable trusts. Leimberg et al. (1993) were among the first to conceptualize the financial planning and investment decision making process. They recommended to the investment managers to summarize the following individual activities in the process of investment and financial planning for an individual: (a) gathering background information, (b) establishing financial objectives, (c) developing financial plans, (d) controlling and executing plans, and (e) measuring performance.
Investor Profiling and Investment Planning: An Empirical Study 19

A number of studies have been conducted to study how risk tolerance varies with the individual demographics, such as gender, age, education and income (Xiao and Noring, 1994; Schooley and Worden, 1996; Shaw, 1996; and Watson and Naughton, 2007). Most of these studies have, however, concentrated on exploring the gender differences in investment choice. The impact of other demographic factors, such as age, education, income, occupation and dependants on investment choice, has not been investigated by many researchers. But whatever studies have been done suggest that they (other demographic factors) affect individuals investment decisions. For example, Grable and Lytton (1999), in a study involving more than 1,000 employees from a Southeastern research university in 1997, determined if demographic, socioeconomic, and attitudinal factors can be used to predict financial risk tolerance. The survey included questions about each respondents gender, age, marital status, occupation, income, education, financial knowledge, and economic expectations. These variables were used as predictor variables in the analysis because they encompass the characteristics that practitioners and researchers have identified as effective in differentiating between levels of financial risk tolerance. Risk tolerance, as determined by each respondents score on the risk assessment measure, was used as the dependent variable. Discriminant analysis was used to classify individuals into risk tolerance categories using respondents demographic, socioeconomic, and attitudinal factors. In this study, they assumed that a persons financial risk tolerance can be classified as either above or below average. It was concluded that an above-average level of risk tolerance was associated with increased levels of attained education, an increased knowledge of personal finance, higher levels of income, and being employed in a professional occupation. Gender, economic expectations, age, and marital status explained proportionately less variance in risk tolerance. Overall, a respondents attained educational level was the best discriminating factor between levels of financial risk tolerance. Another significant finding from this research was that the most widely used demographic for differentiating between levels of risk tolerance by practitioners, a persons age, was relatively ineffective in differentiating between levels of risk tolerance, and instead of being negatively associated with risk tolerance as is commonly assumed by practitioners, the mean age of respondents in the above-average risk tolerance category was higher than the mean age of respondents in the below-average risk tolerance category. Mittal and Vyas (2007) investigated how investment choice gets affected by the demographics of the investor. Their study was based on responses obtained from the respondents belonging to a wide cross section. Non-probabilistic sampling method was employed to select the respondents. The final sample size was 428. The statistical tools used in the study were ANOVA, Mann-Whitney U-test and chi-square test. They found that investors of different age groups do vary significantly with regard to mutual funds and debentures/bonds as their choice of investment avenue. Young investors (26-35) find investing in mutual fund comfortable, while middle-aged investors (36-45) find debentures/bond as more
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comfortable option. On income parameter, they found that people with low income (less than Rs. 1 lakh per annum) like to invest their money in low-risk investments like post office deposits and refrain themselves from investing in equities and mutual funds. Investors with the yearly income between Rs. 1 lakh-2.5 lakh, like to invest in mutual funds, while people with yearly income between Rs. 2.5-4 lakh prefer investing in equities. As far as occupation is concerned, they found that service class people would like to invest their money in equities and mutual funds, while business class showed an inclination to invest their money in debentures/ bonds and real estate/bullions. Housewives prefer safe investments like real estate/bullions, while professionals invest their money in post office deposits and derivatives. Students prefer high risk investments like derivatives and equities. Riley and Chow (1992) tried to find out whether the variables like gender, age, marital status, occupation, self-employment, income, race and education could be used individually or in combination to both differentiate among levels of investor risk tolerance and classify individuals into risk tolerance categories. They used 1992 Survey of Consumer Finances (SCF) as the dataset for study, having a sample size of 2,626 respondents. Discriminant analysis was used to separate, discriminate, estimate, and classify individuals into risk tolerance categories using respondents demographic factors. They found that gender, employment status, education level and income to be effective in discriminating among levels of risk tolerance.

The Effect of Demographics on Risk Taking Behavior and Investment Decision

The impact of each demographic attributes on investment decisions and risk appetite has been explained in this section. Age, income, occupation and number of dependants have been usually taken by researchers (Wallach and Kogan, 1961; Lee and Hanna, 1991; Jagannathan and Kocherlakota, 1996; and Bajtelsmit and VanDerhai, 1997) as demographic variables. The relationship between different demographic variables and risk appetite and their impact on investment decisions are explained below.

Age
It is generally thought that risk tolerance decreases with age (Wallach and Kogan, 1961; Mclnish, 1982; Morin and Suarez, 1983). This can be explained by the fact that older individuals have less time to recover losses than do younger individuals, and as such, risk tolerance decreases with age. There is a substantial consensus among financial advisors that as one ages, the cash portion (i.e., a risk-free asset) of ones portfolio should be increased. Wallach and Kogan (1961) were perhaps the first to study the relationship between risk tolerance and age. Their research indicated that older individuals were less risk tolerant than younger individuals. Jagannathan and Kocherlakota (1996) noted an inverse relationship between age and risk taking. They used the dataset of 298 affluent US-based consumers with mutual fund investments. Descriptive statistics, univariate tests were
Investor Profiling and Investment Planning: An Empirical Study 21

performed via one-way ANOVA and chi-square tests. Multivariate techniques included factor analysis to search for underlying dimensions in the information source and selection criteria variable sets; cluster analysis, to group subjects on the basis of information sources and selection criteria; and discriminant analysis, to determine which variables had the greatest impact on the cluster classifications were used. They suggest that young investors have a long stream of future income. As individuals age, this stream of future income shortens, diminishing the value of their human capital.1 Therefore, they suggest that individuals should offset this decline in the value of their human capital by reducing the risk of their financial portfolio (Bodie et al., l992; and Jaggia and Thosar, 2000). There are also evidences which show a positive relationship between age and risk tolerance (Riley and Chow, 1992; Bajtelsmit and VanDerhai, 1997; Hanna et al., 1998; Grable 2000; and Hallahan et al., 2004). Riley and Chow (1992) tried to find out whether the variablesgender, age, marital status, occupation, self-employment, income, race, and educationcould be used individually or in combination to both differentiate among levels of investor risk tolerance and classify individuals into risk tolerance categories. They used 1992 SCF as the dataset for the study, having a sample size of 2,626 respondents. Discriminant analysis was used to separate, discriminate, estimate, and classify individuals into risk tolerance categories using respondents demographic factors. They found that risk aversion decreases with age until the period, five years prior to the retirement and then increases with age. Hallahan et al. (2004) found a positive relationship between age and risk; they provided evidence as to the behavior and determinants of risk tolerance. The database consists of a psychometrically derived financial Risk Tolerance Score (RTS)2 for over 20,000 surveyed individuals as well as each respondents demographic characteristics (age, number of dependants, gender, marital status, education, personal income, combined family income and net assets). Hierarchical regression analysis was employed to assess which of the variables make a significant contribution to the prediction of risk tolerance. They found the RTS of 60 plus age group to be higher than that of the people in lower age group, and as such concluded that risk appetite does not decrease with age.

Income
Researchers (Lee and Hanna, 1991; Riley and Chow, 1992; and Schooley and Worden, 1996) have found out a positive pattern between income and financial risk tolerance. Both the absolute income level and return requirements may influence ones investment decisions. High levels of wealth and income should encourage risk tolerance because wealthy investors can tolerate some loss better
1 2

Human Capital is defined as the present value of all future earnings. Risk Tolerance Score (RTS) suggests the investor type (conservative, balanced, aggressive, etc.) attached to ones score. In particular the score provides a useful input to the financial advisors on the level of risk one is willing to accept. The score is calculated after asking the client various questions on time horizon and tolerance for risk.
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than the less wealthy. According to MacCrimmon and Wehrung (1986), upper income persons (i.e., individuals with incomes greater than $70,000 per year) and millionaires (i.e., individuals who derive a portion of their income from assets valued at more than $1 mn) tend to take greater risks than individuals with lower incomes. Investment managers have concluded that increasing income levels are associated with access to more immediate resources, leading some to conclude that increased levels of income lead to increased levels of risk tolerance (Blume, 1978; Cicchetti and Dubin, 1994; Hawley and Fujii, 1993-1994; Xiao and Noring, 1994; Shaw, 1996; and Goodfellow and Schieber, 1997). Bajlelsmit and VanDerhai (1997) used 1993 data provided by a large pension plan sponsor to examine the proportion of household wealth, which was invested in risky pension assets. A sample of 20,000 management-level employees was collected. The respondents in the sample had the choice of directing their pension contributions to employer stock, a diversified equity portfolio, a government bond portfolio, a social choice equity fund, or a guaranteed interest fund. They found that employees with high income invested their money in diversified equity portfolio and as such were willing to take more risk as compared to the employees with low income who preferred to invest their money in government bond portfolio.

Occupation
Occupation refers to the principal activity in which someone engages for pay. Individuals who take less risk typically choose occupations with relatively small economic and political risks. Research has found that investment managers have assumed that self-employment status automatically leads to higher levels of risk-taking. Self-employed individuals are thus likely to choose riskier investments and accept increased investment volatility as compared to people who work for others for a straight salary (Meyer et al., 1961; Grey and Gordon, 1978; and MacCrimmon and Wehrung, 1986). According to Roszkowski et al. (1993), other things being equal, different occupations can be used to differentiate between levels of financial risk tolerance. For example, it has long been believed that self-employed individuals, salespersons, and people employed by private firms rather than public employers tend to be more risk tolerant (both generally and in relation to personal finance issues). There is also a general consensus among researchers and practitioners that individuals employed professionally are more likely to have higher levels of risk tolerance than those employed in non-professional occupations (Grey and Gordon, 1978; Quattlebaum, 1988; Masters, 1989; Haliassos and Bertaut, 1995). Grable and Lytton (1998) and Grable and Lytton (1999), in a study involving more than 1000 employees from a southeastern research university in 1997, determined if demographic, socioeconomic, and attitudinal factors can be used to predict financial risk tolerance. The survey included questions about each respondents gender, age, marital status, occupation, income, education, financial
Investor Profiling and Investment Planning: An Empirical Study 23

knowledge, and economic expectations. These variables were used as predictor variables in the analysis because they encompass the characteristics that practitioners and researchers have identified as effective in differentiating between levels of financial risk tolerance. Risk tolerance, as determined by each respondents score on the risk assessment measure, was used as the dependent variable. Discriminant analysis was used to classify individuals into risk tolerance categories using respondents demographic, socioeconomic, and attitudinal factors. In this study, they assumed that a persons financial risk tolerance can be classified as either above or below average. They concluded that an above-average level of risk tolerance was associated with increased levels of attained education, an increased knowledge of personal finance, higher levels of income, and being employed in a professional occupation.

Dependants
Risk taking capacity is inversely proportional to the number of dependants one has. A young and unmarried person can afford to take a greater risk and rough it out for a while. However, if one is supporting his aged parents and has to pay for his childrens education, he is likely to take lesser amount of risk. Daly and Wilson (2001) suggested that the increased responsibilities accompanying marriage and children will make a man less tolerant of risk. Supportive of this theory is the finding by Sunden and Surette (1998); they provided an evidence as to whether risk taking capacity of an individual changes with an increase in the number of the dependants. They used 1995 data provided by a large pension plan. The dataset consists of 741 samples; independent variables were age, income, dependants and gender. The dependent variable was the choice of the pension plan. Regression analysis was used to determine which of the variable has the greatest impact in making the choice about the pension plan. They concluded that marriage makes both men and women more risk averse in their choices of pension plans. Roszkowski et al. (1993) gave the following reasons as to why an individual having dependants will be willing to take less risk. First, it is assumed that single individuals have less to lose by accepting greater risk compared to married individuals who often have responsibilities for themselves and dependants. Second, it is assumed that married individuals are more susceptible to social risk, which is defined as the potential loss of esteem in the eyes of colleagues and peers if an investment choice leads to increased risk of loss.

Findings Based on Previous Research

The literature review indicated that there is a persistent belief among practitioners and researchers that (a) Men are more risk-tolerant than women; (b) Older individuals are less risk-tolerant than younger people; (c) Single individuals are more risk-tolerant than married individuals; (d) Professionally employed are more risk-tolerant than non-professionals and certain occupations are associated with higher or lower levels of risk tolerance; (e) Individuals with
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greater income have greater risk tolerances than lower income earners; (f) Greater educational attainment is associated with increased risk tolerance; and (g) Increased knowledge of personal finance leads to increased risk tolerance. Although these findings are based on empirical research work, there are researchers who are of the opinion that all the above conclusions may not be true at all points in time and in all cultural contexts. Moreover, most of these works are done in advanced economies and there is an acute lacuna of work in this field in emerging economies. This research is a step in filling up that gap in the literature.

Hypothesis Formulation
As is evident from the literature review, demographic variables play a major role in the risk taking capability of an individual, thereby influencing his investment decision. In this paper, the author proposes to test whether the four demographic variablesage, income, dependants and occupationhave an impact on the risk taking capability of the individual, which ultimately influences his investment pattern. Young people have a long stream of future income and time on their side, and therefore, generally, will be willing to invest in more risky assets. Older individuals have less time to recover losses than do younger individuals, and as such, will not be willing to put their money in risky assets. Thus, Hypothesis 1: The risk taking capacity of an individual decreases with age. As a person becomes older, his risk taking capability decreases. High-income investors can tolerate some loss better than the low-income investor. They may be willing to choose riskier strategies because they can more easily contribute additional investment capital even if they sustain any losses. Thus, Hypothesis 2: There is a positive relationship between risk appetite and income. An individual with higher income will take more risk than a person with less income. A young and unmarried person can afford to take a greater risk because single individuals have less to lose by accepting greater risk as no one is dependent upon him. On the other hand, if a person is supporting his aged parents and has to pay for his childrens education, not only he has to look after his own well-being but also of his dependants. Thus, Hypothesis 3: There is an inverse relationship between risk appetite and dependants. An individual with more dependants will take less risk than the one having no dependants. People holding top positions in organizations or those having their own business can be sure of having a regular income than those at the lower level or working for others, and as such can invest their surplus money in risky assets.

Investor Profiling and Investment Planning: An Empirical Study

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Hypothesis 4: There is a positive relationship between risk appetite and occupation. An individual holding a top management position in an organization can take more risk than the one at lower level.

Methodology
Data Source
The primary source of data for this project is the clients of a reputed multinational bank having operations in India.3 A sample of about 294 clients (all residents of Hyderabad/Secunderabad), who had invested their money in various mutual funds from January 2005 to February 2008, was taken. Information about the gender, age, occupation, designation, dependants, income and risk appetite of the investor was collected. Information on the amount invested in a particular mutual fund, total amount invested and the number of funds in which the investments were made. To understand the risk appetite of the client, risk profiling questionnaire of the bank was used, which the clients were required to fill when their financial planning was done. The questionnaire is provided in Annexure 1.

Data Analysis
Cluster analysis technique was used so as to bring the people having similar risk appetite under one group. Cluster analysis does this by classifying objects into different groups, or more precisely, by partitioning the data set into subsets (clusters), so that the data in each subset (ideally) are homogeneous. To understand the risk appetite of the client, risk profiling questionnaire of the bank was used. The questionnaire consists of seven questions based on investment risk tolerance. The client was asked how they felt about certain financial scenarios. Each question consists of four options and the clients were required to mark an option. The options were converted into a Likert scale of 1-4 by the researcher, where 1 means the lowest risk and 4 means the highest risk. The seven questions and their conversion into Likert scale are shown in Annexure 2.

Stage 1: Cluster Analysis

Outlier Identification in the Cluster Solutions
Outliers are objects with very different profiles, most often characterized by extreme values on one or more variables. Outliers can represent either (1) truly aberrant observations that are not representatives of the general population, or (2) an under sampling of actual group(s) in the population that causes an underrepresentation of the group(s). In both the cases, the outliers distort the true structure and make the derived clusters unrepresentative of the true population structure. Reasonable care has been taken to remove these outliers. Four methods of hierarchical cluster, i.e., between group, within group, Centroid clustering and Wards method were used to remove the outliers. The dendrogram
3

The name of the bank is withheld for confidentiality purposes.

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permits a visual inspection for outliers, where an outlier would be a branch that did not join until very late. The outliers common in all the four methods were to be removed. The outliers founded in different methods are shown in Table 1. Table 1: Outliers Found in Various Methods of Cluster Analysis
Between Within Centroid 110 & 26, 202 & 174, 218 & 154, 68 & 152, 1 & 54, 211 & 3, 46 & 252, 39 & 165, 39 & 161 Within 214 & 247 120 & 115, 124 & 189, 113 & 156, 234 & 272 Wards

Between

214 & 247

110 & 26, 202 & 174, 218 & 154, 68 & 152, Centroid 1 & 54, 211 & 3, 46 & 252, 39 & 165, 39 & 161 Wards

120 & 115, 124 & 189, 113 & 156, 234 & 272

Since no outlier is common in all the four methods, the sample is taken as it is and none of the cases are removed to form the final clusters.

Determining the Number of Clusters

In order to have an idea of the number of clusters, we look at the agglomeration schedule. The change in the coefficient of the agglomeration schedule is used as the basis to determine the initial number of clusters. There is no standard rule among researchers to determine the quantum of change that decides the stopping rule for determination of the number of clusters. We have examined the proportionate change in the value of the coefficient as the criterion for stopping rule. The stopping rule was that if the proportionate change between two successive coefficients is not highly different from the previous one, then that point is taken as a stopping point and the clusters formed are n+1, where n denotes the stopping point. As this is a very subjective rule, we iterated the process in order to find two sets of clusters for each method. These two sets are shown in Table 2. We ultimately resorted to Wards method on deciding on the number of clusters to be made. The rationale for using Wards method is that it has a strong tendency Table 2: Initial Cluster Sets Formed Stage Iteration 1
5 4 5 4

Method

Iteration 2
7 6 6 6
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Between Group Linkage Within Group Linkage Centroid Wards Method Method

Investor Profiling and Investment Planning: An Empirical Study

to split data into groups of roughly equal size. This means that when the clusters differ much in size, the big ones will be split into smaller parts roughly equal in size to the smaller clusters. Moreover, Wards Method does not leave any loose ends. All data are grouped in bite size chunks, which can be studied further quite easily. The final number of clusters to be made was 4. The k means method of clustering used to form final clusters. Table 3 provides an insight as to the final cluster centers. Table 3: Final Cluster Centers
Clusters 1 Risk1 Risk2 Risk3 Risk4 Risk5 Risk6 Risk7 Mean 2.880435 2.250000 2.641304 2.065217 2.326087 1.880435 1.086957 15.13043 2 1.323944 3.802817 2.154930 2.816901 2.422535 2.464789 1.352113 16.33803 3 3.722689 3.285714 3.201681 2.680672 1.521008 3.058824 2.075630 19.54622 4 1.166667 3.916667 4.000000 4.000000 1.416667 3.916667 3.750000 22.16667

An insight as to how the four clusters are different from one another can be obtained from Table 4. The ANOVA table shows the sign value of 0.00, clearly indicating that the four clusters so formed are very much distinct from one another. Table 4: ANOVA
Cluster Mean Risk1 Risk2 Risk3 Risk4 Risk5 Risk6 Risk7 Square df 3 3 3 3 3 3 3 Mean Square df 290 290 290 290 290 290 290 Error F 192.62230 78.61398 55.21957 86.47756 32.06620 107.87400 171.17800 Sign value 0.00 0.00 0.00 0.00 0.00 0.00 0.00

96.14473 37.86803 22.77683 17.91993 17.93003 31.56305 36.63851

0.499136 0.481696 0.412478 0.207221 0.559157 0.292592 0.214037

Profiling of Clusters
Cluster 1: Looking at the demographic attributes of the investors lying in this cluster (Table 5), we found that 38 percent of the investors in the cluster were aged between 46 to 60 years; around 10 percent of the investors were more than 60 years. The mean age of the investors lying in this cluster is 49.37 years.
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Majority of the investors in the cluster were businessmen (40 percent); while the retired and housewives constituted only 12 percent of the total investors in the group. Around 42 percent of the investors in this cluster had an income between Rs. 10,000-25,000; while 37 percent of the investors had income ranging from Rs. 25,000-50,000. Investors having 1-2 dependants constituted around 59 percent, while 30 percent had no dependants at all. The mean number of the dependants of the investors was 1.63. Given the traits of this cluster, one could expect the investors above 45 years of age, who were retired/housewives or were in some services, had income up to Rs. 25,000, had three or more dependants, to form the majority of population of this cluster. As observed in this cluster, investors who were retired/housewives, employed/service were 12 percent and 24 percent respectively. A majority of the investors in the cluster were above 45 years, they accounted for 48 percent of the total investors in the cluster. Around 47 percent of the investors in this cluster had income less than Rs. 25,000. In this cluster, investors having more than three dependants accounted for 11 percent only, while those having 1-2 dependants accounted for 59 percent, hence we can infer that it is not always true that people having no dependants will take high risk. This result contradicts some of the earlier theories that people with no dependants will take more risk. Another interesting observation can be seen here is that businessmen formed a major portion (around 40 percent) of this cluster, thus contradicting some of the earlier theories that self-employed people take more risk. Cluster 2: Looking at the demographic attributes of the investors lying in this cluster (Table 6), we found that 35 percent of the investors in the cluster were aged between 36 and 45 years; around 24 percent of the investors were between 46 and 60 years. The mean age of the investors lying in this cluster was 38.29 years, which clearly indicates that young investors form a very small part of this group. A majority of the investors in the cluster were businessmen (35 percent); while professional and employed people constituted around 22 percent each. An interesting observation to be seen here is that the retired and housewives constituted about 20 percent of the total investors in the group, which is greater than what we observed in the previous group. Around 38 percent of the investors in this cluster had an income between Rs. 25,000-50,000; while 30 percent of the investors had income ranging from Rs. 10,000-25,000. Investors having 1-2 dependants constituted around 46 percent, while 40 percent had no dependants at all. The mean number of the dependants for this cluster was found to be 1.43. Given the traits of this cluster, one could expect the investors from 36 to 60 years of agewho are either employed or professionals, have income between Rs. 10,000 and Rs. 50,000 p.m.have more than 2 dependants to form the majority of population of this cluster. As observed in this cluster, employed and professionals together accounted for 46 percent of the total investors in the cluster. Around 60 percent of the investors in the cluster were between 36 to 60 years. More than 68 percent of the investors in this cluster had income of less than Rs. 50,000. People having more than 2 dependants aggregated to
Investor Profiling and Investment Planning: An Empirical Study 29

Table 5: Cluster 1
Age Percent of Investors in the Cluster 4.3478 21.7391 26.087 38.0435 9.7826

Table 6: Cluster 2
Percent Age of Investors in the Cluster 4.2254 23.9437 35.2113 23.9437 12.6761

Under 25 25-35 36-45 46-60 Above 60 Occupation Others Employed/Service Professional Business and Self Employed Monthly Income (Rs.) Less than 10,000 10,000-25,000 25,000-50,000 Above 50,000

Under 25 25-35 36-45 46-60 Above 60 Occupation

11.9565 23.913 23.913 40.2174

Others Employed/Service Professional Business and Self Employed Monthly Income (Rs.)

19.7183 22.5352 22.5352 35.2113

5.4348 42.3913 36.9565 15.2174

Less than 10,000 10,000-25,000 25,000-50,000 Above 50,000

9.8592 29.5775 38.0282 22.5352

Dependants None 1 or 2 3 or 4 5 and above 30.4348 58.6957 7.6087 3.2609

Dependants None 1 or 2 3 or 4 5 and above 40.8451 46.4789 8.4507 4.2254

merely 12 percent of the total investors in the cluster. In this cluster, businessmen accounted for 35 percent, hence we can infer that businessmen will not always take more risk, thus contradicting some of the earlier findings that self-employed people tend to take more risk. Moreover, people having 1-2 dependants accounted for 47 percent of the cluster, this also contradicts earlier theories that a single person or person having no dependants will take more risk. Cluster 3: This cluster consists of young investors (Table 7)around 39 percent of the investors in this cluster belonged to the age group of 25 to 35 years and around 22 percent of the investors were between 36 and 45 years. The mean age of the investors in the cluster was 31.06 years. Around 33 percent of the investors in this group were professionals, while self-employed people accounted for 30 percent of the group and retired and housewives together accounted for 13 percent in this group. Around 57 percent of the investors in this cluster had an income of more than Rs. 50,000; while 22 percent of the investors had income of between Rs. 25,000 and Rs. 50,000. Around 45 percent of the investors had 1-2 dependants, while 13 percent had 3-4 dependants. The mean number of dependants for this cluster was 1.16. Given the traits of cluster 3, one could
30 The Icfaian Journal of Management Research, Vol. VII, No. 12, 2008

expect those in the age group between 25 and 45 yearswho are either professionals or have their own business, have salary of more than Rs. 50,000 have at the most two dependants to form the majority of population of this cluster. As observed in this cluster, business/self-employed professionals constituted 30 percent and 38 percent respectively. A majority of the investors in the cluster were young investors between 25 and 45 years of age, accounting for 61 percent of the total investors in the cluster. More than 57 percent of the investors in this cluster had income of more than Rs. 50,000. People having no dependants accounted for 39 percent, while those having 1-2 dependants accounted for 46 percent of the total investors in the cluster. An interesting observation to be seen in this cluster: people having three or more dependants accounted for 16 percent of the total investors in the cluster, the highest among all the other clusters, which shows that some investors having more dependants are willing to take more risk. Cluster 4: This cluster consists of around 50 percent of the investors (Table 8), aged between 25 and 35 years and around 33 percent of the investors aged between 36 and 45 years. The mean age of investors in this cluster was found to be 28.42. While around 50 percent of the people were professionals, 33 Table 7: Cluster 3
Age Percent of Investors in the Cluster 0.8403 38.6555 21.8487 26.0504 12.605 Under 25 25-35 36-45 46-60 Above 60 Occupation 13.4454 23.5294 32.7731 30.2521 Others Employed/Service Professional Business and Self Employed Monthly Income (Rs.) 5.8824 14.2857 22.6891 57.1429 Less than 10,000 10,000-25,000 25,000-50,000 Above 50,000 0 8.3333 25 66.6667 0 16.6667 50 33.3333

Table 8: Cluster 4
Age Percent of investorsin the 0 50 33.3333 16.6667 0 cluster

Under 25 25-35 36-45 46-60 Above 60 Occupation Others Employed/Service Professional Business and Self Employed Monthly Income (Rs.) Less than 10,000 10,000-25,000 25,000-50,000 Above 50,000

Dependants None 1 or 2 3 or 4 5 and above 39.4958 44.5378 12.605 3.3613

Dependants None 1 or 2 3 or 4 5 and above 33.3333 50 8.3333 8.3333

31

Investor Profiling and Investment Planning: An Empirical Study

percent were businessmen. Around 67 percent of the investors in this cluster had an income of more than Rs. 50,000; while 25 percent of the investors had income between Rs. 25,000 and Rs. 50,000. Around 50 percent of the investors had dependants, while 33 percent had no dependants. The mean number of dependants for this cluster was 1.37. Conclusions from the Cluster Results: Going by the above findings, we can conclude that investors above 46 years who are self-employed, have monthly income between Rs. 10,000 and Rs. 25,000 and have two dependants could be categorized as conservative investors. Whereas investors who are between 36 and 45 years of age, are self-employed, have monthly income between Rs. 25,000 and Rs. 50,000 and have a dependant could be categorized as moderately conservative investors. On the same lines, investors who are aged is between 26 and 35 years are professionals, having monthly income of more than Rs. 50,000 and one dependant, could be categorized as moderately aggressive investors. Similarly, investors who are up to 35 years of age, are professionals, having income of more than Rs. 50,000 and one or two dependants, could be categorized as aggressive investors.

Stage 2
In the second stage, we tried to find out whether people lying in the above-mentioned clusters tend to invest their money as per their risk tolerance or not. This provides an insight as to where people having specific demographics and risk tolerance invest their money. First of all, the risk involved in the portfolio of the client was calculated. In order to find out the risk involved in the portfolio of the client, we had taken the weighted average of the funds in the portfolio of the client. This weighted average was multiplied by the risk factor of the fund. Risk factor is the numerical value between 1 and 5 given to a mutual fund, which shows the risk involved in the fund. Here, 1 means the risk involved is low, whereas 5 means the risk involved is high. The classification of risk for mutual funds is shown in Table 9. Table 9: Point Allotted to Each Risk Category of Mutual Fund
Risk Points Low Below Average 1 2 3 Average Above Average 4 5 High

The classification of the funds into these five risk categories has been adapted from Value Research Online (www.valueresearchonline.com). They use standard deviation and beta of the fund as criterion for segregating fund into the above-mentioned risk classes. An analysis of the portfolio of clients revealed some interesting results. Firstly, it is observed that the mean portfolio risk of all four clusters is same. The mean
32 The Icfaian Journal of Management Research, Vol. VII, No. 12, 2008

portfolio risk of the cluster is the average of the entire portfolios risk in the cluster. It is calculated as {PR1+PR2+PR3+PRn}/n, here PR1 means the portfolio risk of first respondent lying in the cluster and so on, n is the total number of investors falling in that cluster. The mean portfolio risk of all the four clusters is given in Table 10. Table 10: Mean Portfolio Risk of Various Clusters
Cluster Portfolio Risk Cluster 1 3.1577827 Cluster 2 3.1152332 Cluster 3 3.2681878 Cluster 4 3.4332645

F-test is applied to check if there is a significant difference between the mean risks of the portfolios in the four clusters. The results of the F-test are shown in Table 11. Table 11: Results of F-testANOVA
Sum of Squares Between Groups 1.877 245.602 247.479 df 3 290 293 Mean Square F 0.739 Sign value 0.530

0.626 0.847

Within Groups Total

The ANOVA table showing a sign value of 0.530 clearly indicates that there is no significant difference between the mean portfolio risks of the four clusters. Thus, going by the above results, we can say that the risk involved in the portfolio of the investors between the four clusters is somewhat same. An interesting observation to be noted was in the allocation of funds in the various risk categories of the mutual fund. Table 12 provides an insight into the percentage allocated in various risk categories of mutual fund by the investors lying in the fourth cluster. Table 12: Percentage Allocated on Various Risk Categories of Mutual Fund (Cluster 4)
Risk in Mutual Fund Percent allocated in the fund High 17.3817 Above Average 32.7958 Average 34.6167 Below Average 6.0167 Low 9.0958

As per the results of cluster formation, the mean risk tolerance score for the fourth cluster is the highest, which means that the investors in this group are willing to take more risk. Moreover, this cluster consists mainly of young investors whose mean age is 28.42, the income of these investors is more than Rs. 50,000, and moreover, the mean number of the dependents for these investors was 1.37. Ideally for these investors, a large portion of their investments should have been invested in high risk mutual funds, but as it is evident from the above table, the average and above-average risk mutual funds form a huge percentage of the their portfolio, both of these accounted for around 67 percent of the investors portfolio, whereas high risk mutual funds accounted only for 17.38 percent of the clients portfolio.
Investor Profiling and Investment Planning: An Empirical Study 33

Similarly if we look at the percentage allocations of funds for cluster 1, i.e., the one containing conservative investors we found that (Table 13): Table 13: Percentage Allocated in Various Risk Categories of Mutual Fund (Cluster 1)
Risk in Mutual Fund Percent allocated in the fund High 13.2217 Above Average 26.9254 Average 36.95 Below Average 6.7682 Low 16.2048

The risk mean score for cluster 1 is the lowest indicating that investors in this cluster are willing to take less risk. Since these investors are willing to take less risk, it means that a significant portion of their portfolio should be in low or below average risk mutual funds. But as can be seen from Table 13 that in this case also average and above-average risk mutual fund forms a significant portion of the investors portfolio; together they accounted for 64 percent of the investors portfolio, whereas low and below average risk mutual funds accounted only for 6.76 percent and 16.20 percent respectively of the clients portfolio. The percentage allocation of funds in various risk categories of mutual funds by the investors lying in different clusters is presented in Table 14. Table 14: Percentage Allocation of Funds in Different Risk Categories of Mutual Funds by the Investors of Different Clusters
Risk Cluster 1 Cluster 2 Cluster 3 Cluster 4 High 13.2217 15.8754 15.1352 17.3817 Above Average 26.9254 28.4937 32.1956 32.7958 Average 36.95 27.5496 29.4364 34.6167 Below Average 6.7682 7.3801 8.8966 6.0167 Low 16.2048 20.6759 14.4054 9.0958

It can be seen from the above table that irrespective of the risk appetite, an investor tends to invest his money in average risk mutual funds only. This could be primarily because people do not take much risk when the question of investing their hard-earned money comes.

Conclusion
This analysis of profiling the investors on the basis of their demographics into different risk tolerance categories reveal that younger investors and those with high income are willing to take more risk. The findings also contradict some of the earlier theories that self-employed people and those with less dependants take more risk. The analysis shows that self-employed investors and those with few dependants are willing to take less risk. A detailed investigation as to the money actually invested by the investor in different mutual funds is also done. The results show that irrespective of the risk appetite, an investor tends to invest his money in the average risk mutual funds only. This could be primarily because
34 The Icfaian Journal of Management Research, Vol. VII, No. 12, 2008

people do not take much risk when the question of investing in their hard-earned money comes. Secondly, it might be possible that the criterion for differentiating different types of mutual funds in terms of their risk, as done by www.valueresearchonline.com, is not correct. This questions the very use of standard deviation and beta as the measure for estimating risks when better methods like the Sharpe ratio could be used.

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11. Grable J E (2000), Financial Risk Tolerance and Additional Factors That Affect Risk Taking in Everyday Money Matters, Journal of Business and Psychology, Vol. 14, pp. 625630. 12. Hallahan T A, Faff R W and McKenzie M D (2004), An Empirical Investigation of Personal Financial Risk Tolerance, Financial Services Review Vol. 13, pp. 57-78. 13. Haliassos M and Bertaut C C (1995), Why do So Few Hold Stocks?, Economic Journal, Vol. 105, pp. 1110-1129. 14. Hanna S, Gutter M and Fan J (1998), A Theory Based Measure of Risk Tolerance, Froceedings of the Academy of Financial Services, pp. 10-11. 15. Hawley C B and Fujii E T (1993-1994), An Empirical Analysis of Preferences for Financial Risk: Further Evidence on the Friedman-Savage Model, Journal of Post Keynesian Economics, Vol. 16, pp. 197-204. 16. Jagannathan Ravi and Kocherlakota Narayana R (1996), Why should Older People Invest Less in Stocks than Younger People?, Federal Reserve Bank of Minneapolis Quarterly Review, Vol. 20, No. 3, pp. 11-23. 17. Jaggia S and Thosar S (2000), Risk Aversion and the Investment Horizon: A New Perspective on the Time Diversification Debate, Journal of Psychology and Financial Markets, Vol. 1, No. 3, pp. 211-215. 18. Lee H K and Hanna S (1991), Wealth and Stock Ownership, Proceedings of the Association for Financial Counseling and Planning Education, pp. 126-140. 19. Leimberg S R, Satinsky M J, LeClair R T and Doyle R J (1993), The Tools and Techniques of Financial Planning (4th Ed.), National Underwriter, Cincinnati, OH. 20. MacCrimmon K R and Wehrung D A (1986), Taking risks, New York: The Free Press. 21. Mclnish T H (1982), Individual Investors and Risk-taking, Journal of Economic Psychology, Vol. 2, pp. 125-136. 22. Masters R (1989), Study Examines Investors Risk-taking Propensities, Journal of Financial Planning, Vol. 36, pp. 151-155. 23. Meyer H H, Walker W B and Litwin G H (1961), Motive Patterns and Risk Preferences Associated with Entrepreneurship, Journal of Abnormal and Social Psychology, Vol. 63, pp. 570-574. 24. Mittal Manish and Vyas R K (2007), Demographics and Investment Choice Among Indian Investors, The Icfai Journal of Behavioral Finance, Vol. IV, No. 4. 25. Morin R and Suarez A (1983), Risk Aversion Revisited, Journal of Finance, Vol. 38, pp. 1201-16.
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26. Plsson A (1996), Does the degree of relative risk aversion vary with household characteristics?, Journal of Economic Psychology, Vol. 17, pp. 771-787. 27. Quattlebaum O M (1988), Loss Aversion: The Key to Determining Individual Risk, The Journal of Financial Planning, Vol. 1, No. 1, pp. 66-68. 28. Riley W B and Chow K V (1992), Asset Allocation and Individual Risk Aversion, Financial Analysts Journal, Vol. 48, pp. 32-37. 29. Roszkowski M J, Snelbecker G E and Leimberg S R (1993), Risk tolerance and Risk Aversion, in Leimberg S R, Satinsky M J, LeClair R T and Doyle R J, Jr. (Eds.), The Tools and Techniques of Financial Planning (4th Ed.), pp. 213-225. 30. Schooley D K and Worden D D (1996), Risk Aversion Measures: Comparing Attitudes and Asset Allocation, Financial Services Review, Vol. 5, pp. 87-99. 31. Shaw K L (1996), An Empirical Analysis of Risk Aversion and Income Growth, Journal of Labor Economics, Vol. 14, pp. 626-653. 32. Sunden A E and Surette B J (1998), Gender Differences in the Allocation of Assets in Retirement Savings Plans, American Economic Review, Vol. 88, No. 2, pp. 207-211. 33. Tanze Andrew (2006), What Investors should do Now, Kiplingers Personal Finance, pp. 34-37. 34. Wallach M M and Kogan N (1961), Aspects of Judgment and Decision Making: Interrelationships and Changes with Age, Behavioral Science, Vol. 6, pp. 23-26. 35. Watson John and Naughton Mark Mc (2007), Gender Differences in Risk Aversion and Expected Retirement Benefits, Financial Analysts Journal, Vol. 63, No. 4, pp. 52-62. 36. Xiao J J and Noring F E (1994), Perceived Saving Motives and Hierarchical Financial Needs, Financial Counseling and Planning, Vol. 5, pp. 25-44.

Investor Profiling and Investment Planning: An Empirical Study

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Annexure 1
Risk Profiling Questionnaire
1. Which of the following are possible investment motives for you? Options a. Wealth creation. b. Preserving wealth, after accounting for inflation and taxes. c. Regular income to meet commitments and expenses. d. Building a corpus to meet specific future requirements. 2. Which answer best describes your level of investment experience? Options a. Very experienced. b. Fairly experienced. c. Little experience. d. No experience. 3. What is the anticipated time frame for your intended investment? Options a. Short-term Less than 1 year. b. Short/Medium-term 1 to 3 years. c. Medium-term 4 to 7 years. d. Long-term More than 7 years. 4. How much of an unrealized loss of capital are you prepared to tolerate in your investments? Options a. Between 0-15 percent. b. Between 15 percent and 30 percent. c. Between 30 percent and 50 percent. d. Greater than 50 percent. 5. Looking at the historical returns for the four portfolios given, which investment portfolio would you feel most comfortable with? Options a. Best return was 10 percent, Worst loss was 5 percent. b. Best return was 20 percent, Worst loss was 15 percent. c. Best return was 40 percent, Worst loss was 30 percent. d. Best return was 60 percent, Worst loss was 50 percent. (Contd... )
38 The Icfaian Journal of Management Research, Vol. VII, No. 12, 2008

Annexure 1
Risk Profiling Questionnaire

(...contd)

6. Please indicate which of the following statements best describes your attitude towards investment volatility? Options a. Capital preservation is of critical importance to me and I am looking at low risk investment options. b. I am concerned with capital preservation, but I can tolerate infrequent negative cycles to achieve consistent average returns. c. I understand higher returns means I may have to tolerate several quarters of negative returns. d. My main concern is maximizing capital gains. 7. Generally, investments with higher potential returns also carry higher risk. How much risk are you prepared to take with the investment you are considering now? Options a. I am uncomfortable with taking risks with my money and do not wish to jeopardize my capital. b. I am willing to take some risks in return for some capital growth potential. c. I am comfortable taking moderate risks and investing for the long-term to achieve capital growth. d. I actively seek high capital growth and am willing to potentially suffer a large capital loss in pursuit of significant investment gains.

Annexure 2
Likert Scale Conversion of the Questionnaire
1. Which of the following are possible investment motives for you? Options a. Wealth creation. b. Preserving wealth, after accounting for inflation and taxes. c. Regular income to meet commitments and expenses. d. Building a corpus to meet specific future requirements. Points 4 2 3 1

Rationale: Investment goals impact the asset allocation that may be appropriate for an investor. If the goal is building a corpus to meet specific future requirements, less risky portfolio are normally chosen. If the goal is wealth creation, then riskier portfolio is normally chosen. (Contd... )

Investor Profiling and Investment Planning: An Empirical Study

39

Annexure 2
Likert Scale Conversion of the Questionnaire
2. Which answer best describes your level of investment experience? Options a. Very experienced. b. Fairly experienced. c. Little experience. d. No experience.

(...contd)

Points 4 3 2 1

Rationale: Investment knowledge and experience influence a persons comfort with different types of investments. Some investors are more willing than others to accept periodic declines in the value of the portfolio as a trade-off for potentially higher long-term returns. An investor who has fair amount of experience will take higher risk as compared to the one who is a new entrant. 3. What is the anticipated time frame for your intended investment? Options a. Short-term Less than 1 year. b. Short/Medium-term 1 to 3 years. c. Medium-term 4 to 7 years. d. Long-term More than 7 years. Points 4 3 2 1

Rationale: When investing money it is important to know how long the investment time horizon is. Generally, the shorter the period more is the risk, this is so because in the shorter period one could see wide fluctuations in the movements of the stock, therefore the person investing for the short period will be taking more risk than the one investing for long period. 4. How much of an unrealized loss of capital are you prepared to tolerate in your investments? Options a. Between 0-15 percent b. Between 15 percent and 30 percent c. Between 30 percent and 50 percent Points 1 2 3

Reference # 02J-2008-12-02-01

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The Icfaian Journal of Management Research, Vol. VII, No. 12, 2008