How to Get Market Segmentation Right

The goal of market segmentation—the process of dividing a target market into smaller, defined subgroups of customers with shared characteristics—is to identify the subgroups with the highest potential for profit or growth. Segmentation is a crucial part of any effective marketing campaign, but insights from segment analysis are also widely used to identify niche opportunities and to inform decisions about pricing, distribution, and new product development.

Types of Market Segmentation

There are five primary sets of characteristics that researchers use to divide target markets into subgroups likely to make similar choices about products and services:

Demographic Segmentation: Sorting a market by factors like age, income, education, gender, race, and occupation is the earliest type of market segmentation.

Geographic Segmentation: Previously a subset of demographics, geographic segmentation (including climate and regional factors) is relevant for businesses trying to determine where to sell certain products and how to advertise them.

Firmographic Segmentation: Firmographic is the business counterpart of demographic segmentation. Instead of race, gender, and income, firmographic segmentation sorts companies by factors like size and number of employees to inform strategies for prospective business clients ranging from small local firms to large international corporations.

Behavioral Segmentation: Behavioral segmentation is based—not on the behavior of individual consumers—but on trackable behavior in the marketplace: purchase history, spending habits, browsing history, brand loyalty, and consumption patterns.

Psychographic Segmentation: Closely related to behavioral segmentation, psychographic segmentation identifies customer subgroups based on personality, interests, beliefs, and lifestyle, including factors like hobbies, life goals, values, and priorities.

Yankelovich and Nondemographic Segmentation

In 1964, Daniel Yankelovich, an influential U.S. market researcher and social scientist, introduced the concept of nondemographic segmentation, i.e., the classification of consumers by criteria other than age, gender, and income—which he argued were far less accurate predictors of future purchases than data on actual consumer buying patterns.

Psychographics Replace Demographics: Since then, market segmentation has been widely used, with psychographics replacing demographics as the most common criteria. In a 2006 Harvard Business Review (HBR) article, Yankelovich revisited the subject to make the case that over-reliance on psychographics was no more effective than demographic segmentation. “Despite disappointing performance,” commercials were populated with characters designed to reflect the lifestyles, attitudes, and self-image of viewers: “High-Tech Harry” and “Joe Six-Pack.”

Famous Advertising Flops: Although Yankelovich agreed that psychographics are effective at brand reinforcement and positioning, he argued that the emotions these ads evoke do not drive commercial results, which explains the disappointing results of certain famous advertising campaigns. For example, a 2003 Miller Lite ad that featured mud-wrestling supermodels was so memorable that it made headlines—but it failed to increase sales or grab market share. On the other hand, a different Miller Lite ad campaign—based on a market segmentation that identified light-beer drinkers that would switch brands to get fewer carbohydrates—did actually increase sales and take market share from Bud Light.

Hard Data on Consumer Buying Patterns: In the 2006 article, Yankelovich repeated his original argument that the most effective segmentations are based on criteria that are directly linked—not only to emotional triggers—but also to the attitudes and values that drive how each consumer will view a certain product—which in turn drives the factor with the greatest predictive power: actual purchase behavior. The attitudes that drive purchase behavior do not have to be guesstimated—they are revealed in hard data on consumer buying patterns, including product loyalty and brand loyalty as well as purchase history and channel selection. (Yankelovich also discusses the “gravity of the decision” as a factor in predicting purchase behavior, e.g., the decision about which car to buy has more gravity than which shampoo to buy, etc.)

Segmentation Ground Rules

Instead of segmentation based solely on psychographics, Yankelovich proposed a broader view of nondemographic classification so that the segments identified could inform not only advertising campaigns but also strategy outside the marketing department, including new product development, pricing, and distribution. To get solid intelligence on the urgent business questions the segmentation was commissioned to answer—”which products to develop, which distribution channels to sell them in, how much to charge for them, and how to advertise them”—Yankelovich cautioned marketers not to forget certain ground rules, including:

The Predictive Power of Purchase History: Predominantly psychographic approaches ignore Yankelovich’s precept that past buying patterns are much better predictors of future purchase behavior than any superficial identity—and the hard data can be used to predict long-term business outcomes as well.

Overly Technical Segmentation Alienates Senior Management: As marketing gets more scientific and more specialized, Yankelovich also cautioned marketers to remember that—as they are “flaunt(ing) their technical virtuosity”—remember that the market segments identified must “make intuitive sense” to the senior managers who are the final decision makers. If the marketers fail to clarify how the segments were defined or the segments are somehow inconsistent with a senior executive’s deep experience in the sector, the research will likely never be applied.

Product Features Matter More Than Consumer Identities: Don’t let an over-reliance on consumer identities distract marketing strategy from communicating the product features that are most important to existing and potential customers.

Different Segmentations for Different Purposes: One common mistake that Yankelovich called out was applying a segmentation designed for an advertising campaign to strategies it was never intended to inform, such as market entry, product development, and pricing decisions. Draw one segmentation to strengthen brand identity and very different segmentations to determine which markets to enter and which products to develop. For example, an advertising segmentation for an HVAC company came up with clever psychographic characters (“traditional male” and “woman doing yoga”) but failed to inform executives which segment would be most likely to want to upgrade their HVAC systems. Most importantly, that segmentation failed to identify the segment that the client’s own experience had already correctly identified as the most likely purchasers of an HVAC system: people buying older homes in affluent neighborhoods.

Segmentation Must Be Dynamic: No segmentation is a one-time, complete portrait of customers that “can inform all subsequent marketing decisions.” Segmentations must be part of an ongoing strategy to address urgent business questions as they come up. Not only can consumer needs, attitudes, and behaviors change quickly, they are also constantly being revamped by external factors like evolving market conditions, emerging trends, and new technology. The best segmentations focus on only one or two issues and then are “redrawn as soon as they have lost their relevance.”

How to Avoid Faulty Market Segmentation

A frequently cited statistic from a 2006 survey by Bain & Company is that 81% of CEOs considered customer segmentation “a critical tool for growing profits.” A less frequently cited statistic from that survey is even more interesting: fewer than 25% of CEOs believed that their companies “used segmentation effectively.”

A Harvard Business Review (HBR) article about that survey argued that, all too often, companies hire market research firms to conduct expensive segmentation analysis that identifies what looks like white-space segments—and these customers turn out to be a mirage. For companies who fail to get good value from heavy investments in market segmentation, the authors propose adding two preliminary steps before acting on the research: “finding the sweet spot” (to avoid overly ambitious targeting) and “rigorous self-assessment” (to avoid chasing potential customers the company lacks the capacity to serve).

Success Stories: Market Segmentation

The HBR article on the Bain study gave two case studies of companies who got market segmentation right. By grounding their strategies in “hard data” and “flesh-and-blood” customer behavior, these companies used insights from both A-list customers and dispassionate self-assessments to attract new customer segments and to develop new products aligned to organizational capacity.

The Sweet Spot of Market Segmentation

The first necessary step—before acting on insights from customer segmentation research—is to identify a very important subset of customers that you already have: existing, brand-loyal customers who “really, really like you.” That segment (of course) is not your target—you already have them. Instead, the characteristics of your happiest existing customers are used to find an overlapping subset within the new customer segments that your research generated. That overlap—which the Bain study called “the design target”—will be your sweet spot: the “bull’s-eye” of prospective customers who were not only identified by the new research but who are also very similar to your happiest existing customers. Marketing spend tailored to that refined segment—sometimes a very narrow slice—will likely be highly effective and highly profitable.

American Express: American Express (AmEx) warded off intense competition in the 1990s by ramping up the product line based on the right kind of segmentation analysis. They targeted their sweet spot: prospective customers who shared many of the characteristics of their current best customers, a profitable segment of high spenders. AmEx also used the updated analysis to identify more products to offer to their current happy customers. For example, AmEx created credit cards linked to rewards programs that allowed business executives to rack up frequent flyer miles and hotel points. Although this segment was quite narrow, it turned out to be highly profitable over the long term, in part because marketing costs were minimal. All that AmEx had to do to reach this lucrative executive segment was to offer upgrades to their existing customer base and then let word-of-mouth marketing bring in new customers.

Self-Assessment to Maximize Market Segmentation

The Bain study noted that identifying the sweet spot of customer segmentation is “only half of the growth equation.” The next essential step for every company planning to act on market segmentation is to take an “unflinching inventory” of internal capabilities—both strengths and weaknesses. Marketers and product developers who conduct this kind of rigorous self-assessment can evaluate the prospective customer segments against their current operational strengths and weaknesses—and avoid the costly mistake of pursuing customer segments that the company is not set up to serve and will never be able to turn into happy customers.

Global Investment Bank: As an example of a successful self-assessment, the Bain study used a global investment bank’s resolution of an unaccountable discrepancy: some of the bank’s most profitable existing clients were very happy and some were vocally unhappy. With senior management unsure which segments merited further investment, they made the shrewd decision to survey the happiest segment of existing, profitable clients to find out what the bank was doing so well—and the unhappy profitable customers to find out what the bank was doing so wrong. What the investment bank discovered was invaluable: many of their happiest profitable clients were large, complex companies with complex financing needs, operating in multiple countries, often in heavily regulated industries. This segment of profitable clients appreciated the bank’s technical and regulatory expertise and rated the bankers’ ability to ask probing questions as a strong positive. The bank also learned that many of their unhappy clients were much less complex and had simpler financing needs—and the same expertise that the complex companies considered a strong positive was seen as arrogance and condescension by the unhappy clients with simpler structures. This enlightening self-assessment allowed the bank to focus resources on their sweet spot: the segment of existing and prospective clients that were most likely to have extensive advisory needs.

Which Industries Use Market Segmentation?

Consumer goods, retailing, e-commerce, and media are the most obvious sectors to leverage market segmentation, but all industries benefit from the customer insights that this analysis provides. For example, Grand View Research, a U.S. market research company, provides both syndicated and customized market segmentation reports on every industry: pharma/biotech; financial services; telecommunications; computer software/hardware; materials/chemicals; manufacturing/construction; transportation/shipping; energy/resources; and agriculture.

In addition to industry players, market segmentation research is conducted on behalf of government agencies, educational institutions, and law firms—and even advertising and marketing firms. For example, Bloomberg reported the results of a segmentation study on the customer experience (CX) management market, which is expected to hit $38.98 billion by 2030, with compound annual growth rate (CAGR) of 18.1% from 2022 to 2030, across their mobile touchpoint, cloud-based, end-use, and BFSI (banking, financial services and insurance) segments.