Review of Financial Studies· 2013Q1
Common Errors: How to (and Not to) Control for Unobserved Heterogeneity
- 1,141citations
- Q1SCImago
- 2013year
Short summary
Demeaning dependent variables or adding group means as controls are inconsistent and distort inference for unobserved heterogeneity; fixed effects estimators are consistent and recommended.
AI-generated from the title and abstract; the full text is not read.
Key points
- Demeaning dependent variables by group (e.g., industry-adjusting) is an inconsistent method for controlling unobserved heterogeneity.
- Adding the group's mean dependent variable as a control also produces inconsistent estimates and distorts inference.
- Fixed effects estimators are shown to be consistent and are the recommended approach for controlling unobserved heterogeneity.
- Methods are provided for estimating fixed effects models when traditional approaches are computationally infeasible.
AI-generated from the title and abstract; the full text is not read.
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.
The authors' abstract, as published at the source. Review of Financial Studies, 2013 · DOI ↗
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Field: General Economics, Econometrics and Finance
General Economics, Econometrics and FinanceEconomics, Econometrics and Finance