Abstract

http://ssrn.com/abstract=2023868
 
 

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Common Errors: How to (and Not to) Control for Unobserved Heterogeneity


Todd A. Gormley


University of Pennsylvania - The Wharton School

David A. Matsa


Northwestern University - Kellogg School of Management; National Bureau of Economic Research (NBER)

August 3, 2013

Review of Financial Studies, 2014, 27(2), 617-61
AFA 2013 San Diego Meetings Paper

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.

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Number of Pages in PDF File: 58

Keywords: unobserved heterogeneity, group fixed effects, industry-adjust, bias

JEL Classification: G12, G2, G3, C01, C13

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Date posted: March 17, 2012 ; Last revised: June 17, 2014

Suggested Citation

Gormley, Todd A. and Matsa, David A., Common Errors: How to (and Not to) Control for Unobserved Heterogeneity (August 3, 2013). Review of Financial Studies, 2014, 27(2), 617-61; AFA 2013 San Diego Meetings Paper. Available at SSRN: http://ssrn.com/abstract=2023868 or http://dx.doi.org/10.2139/ssrn.2023868

Contact Information

Todd A. Gormley (Contact Author)
University of Pennsylvania - The Wharton School ( email )
The Wharton School
3620 Locust Walk
Philadelphia, PA 19104
United States
(314) 313-4330 (Phone)
HOME PAGE: http://apps.olin.wustl.edu/faculty/Gormley/

David A. Matsa
Northwestern University - Kellogg School of Management ( email )
2001 Sheridan Road
Evanston, IL 60208
United States
847-491-8337 (Phone)
847-491-5719 (Fax)
National Bureau of Economic Research (NBER) ( email )
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
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