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

58 Pages Posted: 17 Mar 2012 Last revised: 11 Aug 2020

See all articles by Todd A. Gormley

Todd A. Gormley

Washington University in St. Louis; European Corporate Governance Institute (ECGI)

David A. Matsa

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

Date Written: August 3, 2013

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

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

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, Jacobs Levy Equity Management Center for Quantitative Financial Research Paper, Available at SSRN: https://ssrn.com/abstract=2023868 or http://dx.doi.org/10.2139/ssrn.2023868

Todd A. Gormley (Contact Author)

Washington University in St. Louis ( email )

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European Corporate Governance Institute (ECGI) ( email )

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David A. Matsa

Northwestern University - Kellogg School of Management ( email )

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National Bureau of Economic Research (NBER) ( email )

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