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Common errors: How to (and not to) control for unobserved heterogeneity, (2014)
| Venue: | Review of Financial Studies |
| Citations: | 18 - 2 self |
BibTeX
@ARTICLE{Gormley14commonerrors:,
author = {Todd A Gormley and David A Matsa and Michael Anderson and Joshua Angrist and Xavier Giroud and Christian Hansen and Dirk Jenter and Sandy Klasa and Jonathan Lewellen and Alexander Ljungqvist and Mitchell Petersen and Nagpurnanand R Prabhala and Michael Roberts and Nick Souleles and Michael R Wagner and Toni Whited and Jeffrey Wooldridge},
title = {Common errors: How to (and not to) control for unobserved heterogeneity,},
journal = {Review of Financial Studies},
year = {2014},
pages = {617--661}
}
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Abstract
Abstract Controlling for unobserved heterogeneity (or "common errors"), such as industry-specific shocks, is a fundamental challenge in empirical research. This paper discusses the limitations of two approaches widely used in corporate finance and asset pricing research: demeaning the dependent variable with respect to the group (e.g., "industry-adjusting") and adding the mean of the group's dependent variable as a control. We show that these methods produce inconsistent estimates and can distort inference. In contrast, the fixed effects estimator is consistent and should be used instead. We also explain how to estimate the fixed effects model when traditional methods are computationally infeasible. (JEL G12, G2, G3, C01, C13)
