Logo Logo

Common Errors: How to (and Not to) Control for Unobserved Heterogeneity, Review of Financial Studies

Abstract

Controlling for unobserved heterogeneity, or common errors, such as industry-specific shocks, is a fundamental challenge in empirical research. This paper discusses limitations of two approaches widely used in corporate finance and asset pricing research demeaning the dependent variable with respect to the group, such as industry adjusting, and adding the mean of the groups 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.

Type

Article

Author(s)

David A. Matsa, Todd Gormley

Date Published

2014

Citations

Matsa, A. David, and Todd Gormley. 2014. Common Errors: How to (and Not to) Control for Unobserved Heterogeneity. Review of Financial Studies. 27(3): 617-661.

KELLOGG INSIGHT

Explore leading research and ideas

Find articles, podcast episodes, and videos that spark ideas in lifelong learners, and inspire those looking to advance in their careers.
learn more

COURSE CATALOG

Review Courses & Schedules

Access information about specific courses and their schedules by viewing the interactive course scheduler tool.
LEARN MORE

DEGREE PROGRAMS

Discover the path to your goals

Whether you choose our Full-Time, Part-Time or Executive MBA program, you’ll enjoy the same unparalleled education, exceptional faculty and distinctive culture.
learn more