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

@inproceedings{Gormley2012CommonE,
  title={Common Errors : How to ( and Not to ) Control for Unobserved Heterogeneity},
  author={Todd A. Gormley and David Abraham Matsa},
  year={2012}
}
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… CONTINUE READING
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