Common errors: How to (and Not to) control for unobserved heterogeneity

Todd A. Gormley*, David A. Matsa

*Corresponding author for this work

Research output: Contribution to journalArticlepeer-review

286 Scopus citations

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.

Original languageEnglish (US)
Pages (from-to)617-661
Number of pages45
JournalReview of Financial Studies
Volume27
Issue number2
DOIs
StatePublished - Feb 2014

ASJC Scopus subject areas

  • Accounting
  • Finance
  • Economics and Econometrics

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