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

Abstract:     
Controlling for unobserved heterogeneity (or “common errors”), such as industry-specific shocks, is a fundamental challenge in empirical research. Failing to do so can introduce omitted variables biases and preclude causal inference. This paper discusses limitations of two approaches commonly used to control for unobserved group heterogeneity in finance 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 techniques, which are used widely in both asset pricing and corporate finance research, typically provide inconsistent coefficients and can lead researchers to incorrect inferences. 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.

Additional programming advice is available online.

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

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

working papers series