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The present study focused on one of the important South Asian nations—Sri Lanka—to examine the role of idiosyncratic volatility in asset prices. A four-factor model with idiosyncratic volatility was designed for capturing the market, size, value and idiosyncratic risk yields better than Fama and French’s (J Financ Econ 33:3–56, 1993) three-factor model and performance of the model. Fama–MacBeth’s cross-sectional regression, residual graphs and GRS test all confirm the superiority of four-factor model over 2 three-factor models. For all MC- and IVOL-based portfolios, idiosyncratic volatility is negatively related to the expected returns and positively related for all PB-based portfolios. Finally, study findings confirm that there is a high importance for idiosyncratic volatility risk factor while considering investment decision in Colombo stock exchange. Hence, investor should compensate for holding such risk factors in the portfolio.

Is idiosyncratic risk ignored in asset pricing: Sri Lankan evidence?