Kaiser Criterion in Factor Models

Abstract

Despite of the wide use of the factor models, the issue of determining the number of factors has not been resolved in the statistics literature. An ad hoc approach is to set the number of factors to be the number of eigenvalues of the data correlation matrix that are larger than one, and subsequent statistical analysis proceeds assuming the resulting factor number is correct. In this work, we study the relation between the number of such eigenvalues and the number of factors, and provide the if and only if conditions under which the two numbers are equal. We show that the equality only relies on the properties of the loading matrix of the factor model. Guided by the newly discovered condition, we further reveal how the model error affects the estimation of the number of factors.