The Risk Most Portfolios Do Not Explicitly Manage

Most portfolios are constructed on a simple and widely accepted assumption: that equity risk will be rewarded over time.

For long-term investors, this has generally proven to be a reasonable foundation. Equity markets, despite periods of volatility, have historically delivered positive returns over extended horizons.

However, this assumption contains an important limitation. It relies not only on the magnitude of returns, but also on the path by which those returns are achieved.

For investors in or approaching retirement, that path matters significantly.

 

Why Sequence Matters More Than Averages

In accumulation, negative returns can be absorbed. Contributions continue, capital is added, and time allows for recovery.

In retirement, the dynamic changes.

Withdrawals begin. Capital is no longer being added. The ability to recover from losses is constrained not only by time, but by the ongoing need to fund income.

A negative return early in retirement does not simply delay outcomes. It can permanently impair the capital base from which future returns are generated.

This is the essence of sequence risk: the order in which returns occur has a direct and lasting impact on investor outcomes.

Two portfolios with identical long-term average returns can produce materially different results depending on when those returns are realised.

A detailed illustration of sequencing risk, including step-by-step portfolio outcomes under different return paths, is set out in Risk-Managed Investing: A Structured Path From Accumulation to Retirement (see pages 12–13), available here:

https://www.gyrostat.com.au/assets/Uploads/2025-07-06-Gyrostat-Risk-Managed-Investing-eBook.pdf

 

How Portfolios Currently Manage Risk

Despite the importance of sequence risk, most portfolios do not explicitly manage it.

Instead, risk is addressed indirectly through a combination of diversification, asset allocation, and time horizon assumptions.

Diversification aims to reduce volatility by spreading exposure across asset classes. Asset allocation seeks to balance growth and defensive assets. Time is relied upon as the mechanism through which temporary losses are recovered.

These are well-established and valuable tools. However, they share a common characteristic: they assume that markets will recover, and that investors will remain invested through periods of drawdown.

In practice, this means that when equity markets fall sharply, portfolios are often left fully exposed to that decline.

 

The Gap in Portfolio Construction

This creates a structural gap.

While portfolios are designed with careful attention to expected returns and long-term outcomes, there is often no dedicated allocation whose purpose is to manage equity downside risk as it occurs.

The implicit approach is one of endurance: remain invested, rely on diversification, and allow time to restore value.

For many investors, particularly those in retirement, this can be a challenging assumption.

Drawdowns are not experienced in isolation. They occur alongside withdrawals, client anxiety, and the behavioural pressures that can lead to suboptimal decisions.

As a result, the practical experience of risk can differ materially from its theoretical treatment.

 

Source: Gyrostat Capital Management Behavioural Framework

 

Reframing The Role of Risk Management

If sequence risk is to be addressed more directly, it requires a shift in how portfolios are constructed.

Rather than relying solely on diversification and time, there is a case for introducing allocations with a specific and clearly defined role: to manage downside risk within equity exposure.

This does not replace the need for growth assets, nor does it eliminate risk. Instead, it recognises that risk can be actively managed, rather than passively endured.

Such an approach focuses not only on expected returns, but on the behaviour of the portfolio under adverse conditions.

In particular, it considers how losses are limited, how capital is preserved, and how investors are supported through periods of market stress.

 

From Recovery to Protection

The distinction between recovery and protection is subtle but important.

A recovery-based approach accepts drawdowns and relies on subsequent market performance to restore value.

A protection-based approach seeks to manage the extent of those drawdowns as they occur.

This can be achieved through the use of explicit downside protection mechanisms, including listed derivatives, applied within a disciplined and transparent framework.

When implemented effectively, such strategies can reduce the depth of losses during market downturns, while maintaining participation in positive market environments.

The objective is not to eliminate volatility, but to improve the overall path of returns.

Source:  Gyrostat Capital Management market scenarios framework

 

Implications for Advisers and Investors

For advisers, the inclusion of explicit downside management can alter the way portfolios are experienced by clients.

Reduced drawdowns can support more stable capital trajectories, particularly in retirement, where sequencing effects are most pronounced.

Equally important, it can influence behaviour. When losses are more contained, investors may be less likely to make reactive decisions during periods of stress.

This, in turn, can improve the likelihood that long-term investment strategies are maintained.

The implications of this are not theoretical. They directly influence how portfolios behave in retirement, and how advisers and clients experience risk in practice.

 

A More Complete Framework

Portfolio construction has evolved significantly over time, incorporating new asset classes, risk measures, and implementation techniques.

However, the explicit management of equity downside risk remains less commonly embedded as a distinct allocation.

As the investor base continues to age, and as the focus on retirement outcomes intensifies, this may become an increasingly important consideration.

Risk is not defined solely by volatility or long-term averages. It is defined by the consequences of adverse outcomes, particularly when those outcomes occur at the wrong time.

Portfolios that explicitly recognise and address this dimension of risk may be better positioned to meet the needs of both advisers and their clients across the full market cycle.

 

Recent Performance Snapshot

For the quarter ended 31 March 2026, Class A returned +3.66% and Class B returned +6.20%.

 

Gyrostat Capital Management prepared this document and it is intended only for Australian residents who are wholesale clients (as defined in the Corporations Act 2001). To the extent any part may be perceived as financial product advice, it is general advice only and has been prepared without taking into account of the reader’s investment objectives, financial situation or needs. Anyone reading this report must obtain and rely upon their own independent advice and inquiries. Investors should consider the Product Disclosure Statement (PDS) relevant to the Fund before making any decision to acquire, continue to hold or dispose of units in the Fund. You should also consult a licensed financial adviser before making an investment decision in relation to the Fund. One Managed Investment Funds Limited ACN 117 400 987 AFSL 297042, is the responsible entity of the Fund but did not prepare the information contained in this document. While OMIFL has no reason to believe that the information is inaccurate, the truth or accuracy of the information in this document cannot be warranted or guaranteed.