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Behavioral Finance and Estimating the Return on Equity. SURFA 40 th Annual Financial Forum March 2008 Introductory Comments Enrique Bacalao Assistant Treasurer Alliant Energy Corporation. Why should we make an effort and push the envelope?.

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behavioral finance and estimating the return on equity

Behavioral Finance and Estimating the Return on Equity

SURFA 40th Annual Financial Forum

March 2008

Introductory Comments

Enrique Bacalao

Assistant Treasurer

Alliant Energy Corporation

why should we make an effort and push the envelope
Why should we make an effort and push the envelope?
  • ROE is not a clean-cut determination
  • The established methodology has its shortcomings
    • Simplifying but distorting assumptions
    • Empirical and predictive shortcomings
    • Generally assumes rational investors
  • We should be attempting to describe actual, as opposed to theoretical, investor behavior
why should one bother with actual investor behavior
Why should one bother with actual investor behavior?
  • The objective is to establish a fair and reasonable ROE – one that reflects real investors’ actually required return on equity
  • Improperly setting an ROE too high or too low has adverse financial repercussions
  • An improperly set authorized ROE level eventually hurts all interested parties
  • We need to understand how investors make actual investment decisions, in order to better understand and predict how they will react to a given authorized ROE.
can actual investor behavior be properly observed and measured
Can actual investor behavior be properly observed and measured?
  • Anyone who has been an active and/or professional investor, or who has interacted professionally with active investors, recognizes certain irrational decision-making patterns that crop up
  • Investor risk / return trade-off decisions are not consistently rational
  • Recent academic work, collectively referred to as behavioral finance, has begun to study and illuminate these patterns.
what insights does behavioral finance offer in determining roe
What insights does behavioral finance offer in determining ROE?
  • Market under- and over-reactions
  • Herd behavior
  • Overconfidence
  • Loss aversion
  • Perceptions of the comparability of risks
  • Confirmation bias
  • Escalation of effort
  • Anchoring and expectation formation
  • Regulatory risk perceptions
should one take note of actual investor behavior
Should one take note of actual investor behavior?
  • Yes, if one wants to begin to understand investor behavior, particularly in markets under stress, as witnessed recently
  • Yes, if one, as a regulator, wants to successfully induce the intended reaction among investors in framing ROE decisions
  • Yes, if one wants to honor the U.S. Supreme Court landmark cases we all refer to (Hope and Bluefield, among others)
does this field complement or does it invalidate accepted theory
Does this field complement, or does it invalidate, accepted theory?
  • I invite you to ponder this question during the course of our discussion panel
  • In my own view, no single ROE estimation methodology has demonstrated its overwhelming superiority over the others
  • It would therefore be foolish to disregard any valid insights that behavioral finance can offer into investor decision-making, particularly as the behavior patterns impact their required ROE decisions in real life
what standards should these new insights meet to be accepted
What standards should these new insights meet to be accepted?
  • Are the studies properly designed and statistically valid?
  • Can the results be replicated?
  • What are their predictive value?
  • Are the conclusions universally applicable?
  • Can we establish the limits of their applicability?
  • Can we identify extraneous factors that might contaminate the conclusions one can safely draw?
what reasonable requirements should regulators impose
What reasonable requirements should regulators impose?
  • Credibility and general acceptance?
  • Publication of findings in general and business media with increasing frequency?
  • Broadening familiarity with, and application of, behavioral finance among the:
    • Academic community?
    • Investor community?
    • Corporate finance community?
    • Regulatory community?
  • Considered orthodox? If so, by whom?
where do we currently stand in this process
Where do we currently stand in this process?
  • Increasing mainstream acceptance in the academic community
  • Nobel Prize in Economics (Daniel Khaneman and Vernon L. Smith in 2002)
  • Confirmation of insights by practitioners among the investment and corporate finance communities
  • Increasing acceptance among financial market regulatory bodies
  • Early days in contested rate cases (Wisconsin precedent)
introducing the discussion panel members
Daniel Read

Professor of Behavioural Economics

Durham Business School

Behavioral finance and the insights it offers into investor decision-making

Behavioral economics, particularly in the domain of inter-temporal choice

Introducing the discussion panel members
introducing the discussion panel members12
G. Kevin Spellman

Director, Hawk Center for Applied Security Analysis

University of Wisconsin

Consultant

International Strategy and Investment Group

Applying investment practice and behavioral finance theory to the estimation of a regulated ROE

The precedent of the Wisconsin Power and Light Company retail rate case

(docket 6680-UR-115)

Introducing the discussion panel members
introducing the discussion panel members13
J. Robert Malko

Professor of Finance

College of Business

Utah State University

What regulators should reasonably require in giving credence to new academic insights

Integrating behavioral finance into the pantheon of accepted ROE methodology

Introducing the discussion panel members
behavioral finance and estimating the return on equity14

Behavioral Finance and Estimating the Return on Equity

SURFA 40th Annual Financial Forum

Discussion Panel 3

March 2008