PITFALLS IN THE APPLICATION OF DISCRIMINANT ANALYSIS IN BUSINESS, FINANCE, AND ECONOMICS

OF THE APPLIED DISCRIMINANT analysis papers that have appeared in the business, finance, and economics literature to date, most have suffered from methodological or statistical problems that have limited the practical usefulness of their results. While it is not true that the statistical problems are unique to economics or finance, it does seem that the nature of the subject matter and data are such that one can expect to encounter statistical difficulties more frequently than in many other application areas. The problems are of several different types, among which are difficulties with (1) the distributions of the variables, (2) the group dispersions, (3) the interpretation of the significance of individual variables, (4) the reduction of dimensionality, (5) the definitions of the groups, (6) the choice of the appropriate a priori probabilities and/or costs of misclassification, and (7) the estimation of classification error rates. The purpose of this paper is to discuss these problems of application of discriminant analysis techniques. Ample references are made to the literature for examples to illustrate the pitfalls. Finally, a brief discussion of future problems and prospects for statistical research on the application of the techniques is provided.

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