Common Errors: How to (and Not to) Control for Unobserved Heterogeneity
Review of Financial Studies, 2014, 27(2), 617-61
58 Pages Posted: 17 Mar 2012 Last revised: 11 Aug 2020
Date Written: August 3, 2013
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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Keywords: unobserved heterogeneity, group fixed effects, industry-adjust, bias
JEL Classification: G12, G2, G3, C01, C13
Suggested Citation: Suggested Citation