Spurious Stochastics in a Short Time-Series Panel Data

Abstract

This paper analyzes the effects of individual-specific size factors in a dynamic panel regression model. Theory and simulation show that an individual-specific size factor, with a fat-tailed distribution or a time- varying property, may cause spurious stochastics. If a pair of panel variables depends on size in some way, then they appear to find a strong relationship, if the size variable is not used in the regression, even if the variables are otherwise independent. Moreover, forecasts based on models that have omitted size-factors are affected seriously by the property of the size-factors. A pooling regression with very short time-series appears to fit well in sample, but forecasts poorly out-of-sample if the neglected indivi- dual-specific size-factor has a fat-tailed distribution.