3 things investors can learn about risk from the U.S. Army

Major Hugh Jones is a professor of finance and economics at the United States Military Academy and has had two tours of duty in Iraq. He also has an MBA from Duke.

He spoke last year at the CARE conference (Center for Accounting Research and Education conference) about how the U.S. Army deals with high-stakes risk. The video below is his presentation at CARE (thanks to Professor Darren Roulstone for bubbling up  his speech!).

You can get slides of Major Jones presentation here  [.pdf].

Heres what investors can learn from how the U.S. Army deals with risk.

The US Armys Risk Mitigation program

Defining risk

The U.S. Army separates the definition of risk from uncertainty (like we did in last weeks post on defining investment risk ).

• Risk. known hazards (things we can identify that can cause harm)
• Uncertainty: unknown hazards (anything unpredictable and ambiguous that can arise from complex systems.)

Managing risk

How does the army deal with managing a road that is the most heavily laden with explosives in the World?

The Army has a feedback loop to handle managing its risks that involved an unending process to identify all known hazards, assess them, and then develop tools and procedures to control for these pitfalls.

Putting risk management into practice

The army uses two types of solutions to manage risk and uncertainty:

1. information-based solutions. collect more and better data

1. for this to work, need superior information
2. need a system to disseminate right info to the right person, continuously pushing and pulling information
3. facilitates collaborative planning
4. Needs massive storage to house all virtual and physical infromation

Forecasting the future: using information solutions

When the Army goes into battle, it draws up two plans: the most likely scenario and the worst-case scenario .

These arent static scenarios they are always changing based upon new assessments from the field. The army uses what it calls, Red Teams to provide an independent capability to challenge plans in the context of whats happening.

Action-focused solutions

These solutions admit that there will always be some uncertainty its unavoidable. So the organizations must deal with knowing that they dont always know.

So, to move forward in a risk-aware environment, the Army has developed mission command: a hierarchy of decision making that empowers people closest to the ground to make knowledgable decisions instead of going through an onerous decision making process.

Mission command sacrifices direct control for initiative and action.

What investors can learn from the army

So, whats the point here? Heres what investors can take away from how the Army manages risk and uncertainty.

1. need different types of solutions. investors need a plan of action that proactively deals with risk but simultaneously, continues to assess the information landscape out there, updating with new known information. Investor frequently suffer from paralysis from analysis theres just too much info 24/7. So we need action, too.
2. admit that we cant know everything. the Armys action plan at its core admits it needs to move forward without understanding every eventuality. Thats OK and its developed a proactive chain of command to help all its participants to make the best decisions they can, when they can.
3. red teams = investment teams. I like the concept of specific teams to help bubble up fresh, contrarian ideas to challenge the status quo thinking. Having people whose responsibility it is to broaden everyones understanding is super  valuable. Its like an internal consultant and oversight body, yet challenges groupthink.

Whether youre an individual investor managing your IRA or a portfolio manager running billions of dollars, you need a system to manage risk.