How to properly calculate and manage risk is one of the most important lessons that the military teaches to service members. Even though the financial risk that civilians are required to manage might be quite different from the risks that the members of the military deal with, many of the same lessons still apply. In this article, we will explore what you can learn from how the military manages risk and how those key lessons can be applied to financial risk management.
How the Military Categorizes Risk
One of the most well-known examples of how the military categorizes risk is the Defense Ready Condition system, or DEFCON system. This system was created in 1959; as this was when the threat of nuclear war with the Soviet Union was still a clear and present danger. So, the DEFCON system uses DEFCON levels to prescribe five graduated levels of readiness for nuclear war. DEFCON 5 describes the lowest level of risk. This level is in place during times of world peace when the risk of nuclear war breaking out is negligible. DEFCON 1, meanwhile, describes a scenario where nuclear war is imminent and likely unavoidable. Fortunately, we have never reached DEFCON 1. DEFCON 2, during the Cuban Missile Crisis, ranks as the highest level ever confirmed. At the time of this writing, the US military is currently at DEFCON 3 due to the ongoing conflict between Russia and Ukraine.
These DEFCON levels might not mean much to the average citizen. However, they do provide a great template for how to categorize financial risk. During periods of economic stability and growth, you might categorize your investment portfolio as DEFCON 5. This means that it might not need that much supervision. During periods of severe economic downturn and market volatility, you might categorize your portfolio as DEFCON 1. This would mean that you should approach your financial strategy with absolute readiness. In addition to that, you should also be practicing continual monitoring, and careful risk management.
The 5 Steps of Army Risk Management
The United States Army has developed a system for calculating and managing risk called Army Risk Management. Under this system, there are five steps to utilize to manage risk:
- Identify hazards
- Assess hazards
- Develop controls and make risk decisions
- Implement controls
- Supervise and evaluate controls
For the Army, this process is used to evaluate and manage the risk of military operations in combat zones. Civilians can also use this same process to evaluate and manage financial risk. Let’s take a look at how this might work:
1) Identify Hazards
Anytime you make an investment or another financial decision, it is essential to identify potential hazards. If you are purchasing stock in a company, this might mean identifying the potential hazards. More specifically, these are hazards that could cause the company’s stock to drop; whether that’s outside economic factors or potential headwinds within the company itself.
2) Assess Hazards
Once you have identified the potential hazards associated with an investment or financial decision, the next step is to assess how much risk those hazards actually present. This entails considering both the likelihood of those hazards coming to fruition. Additionally, it entails considering the damage that they will cause if they do. Hazards that are both unlikely and not that consequential are ones that you probably don’t have to worry about. Hazards that are more likely to happen and/or more costly if they do should serve as red flags signaling that it’s a good idea to avoid an investment.
3) Develop Controls and Make Risk Decisions
Having both identified and assessed the hazards associated with an investment, you are now in a position to make a risk decision. As for developing controls to manage risk, this is often difficult to do when making investments and managing financial risk. For a military operation, the Army is able to develop controls such as reinforcing positions, gathering extra intelligence, and much more. When managing financial risk, deciding where and when to invest your money is the only real control you have available. Nevertheless, this can still be a powerful control to implement. For example, diversifying your portfolio, maintaining adequate liquidity, and monitoring your investments regularly are all effective ways to develop controls for financial risk.
4) Implement Controls
Once you have made a financial decision and identified the controls that will help manage its risk, it’s time to put those controls into practice. What exactly this looks like will depend on the specific nature of your financial decision and the controls that you identify.
5) Supervise and evaluate controls
Managing financial risk is an ongoing process of careful monitoring and evaluation. If you want the controls that you implement to actually keep your risk as low as possible, it is essential to continually evaluate your results.
Final Thoughts
The military requires its members to evaluate and manage a lot of different risks. As civilians, we are fortunate to not have to contend with the same types of risks as those in the military routinely face. However, to manage their own financial risk, civilians can certainly apply the same risk strategies the military developed over the years. By categorizing your financial risk using a system similar to the DEFCON system and by evaluating and managing risk using the 5 steps of Army Risk Management, you can help ensure that your financial decisions are sound and that your investment portfolio is as well-protected as possible.
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July 15, 2022 at 08:47AM by Maya Johnson, Khareem Sudlow
