The Swiss National Bank made history the other day, ending a self-imposed cap it placed on its currency that kept each franc pegged tightly to the euro.
The currency gained about 30% against a basket of global currencies overnight after the cap was removed, catching global investors by surprise, bankrupting hedge funds, and throwing currency brokers out of business.
Here are a few takeaways.
A few hedge funds that trade currencies blew up because they didn't see this coming. In their defence, this has never happened before. Can we blame them?
Sure you can. There is an entire field of study devoted to things that never happened before they happened. It's called "history". It emphasises that surprises happen all the time.
A hedge fund's job is to prepare for the unexpected. This is why Warren Buffett said his successor needed to be "someone genetically programmed to recognise and avoid serious risks, including those never encountered before".
But come on. Goldman Sachs chief financial officer Harvey Schwartz said this was a like 20-sigma event, meaning, statistically, a move this big should happen only once every four billion years.
The stupidity of that statement is a 20-sigma event. Russia defaulting on its debt in 1998, the subprime mortgage collapse, junk bond outflows last summer, and the Swiss bank's move last week were all moves that Wall Street models said should have occurred only once every billion years. When once-every-billion-year events happen every four years, maybe - maybe - it's your models that are wrong.
So, how often should these out-of-the-blue events take place?
You can't expect these kinds of things to occur, or not occur, at any given rate. That's their nature. What's dangerous is assuming these kind of big events happen in smooth, predictable ways.
Currency trading in general is dangerous, right?
Yep. More than 60% of individual currency traders lose money every quarter, Forex Magnates says.
Whoa. Why?
A few reasons. Currencies are based around trading, rather than buying and holding. Since big investors are always going to have better, faster information networks than small traders, the odds of gaining an edge are stacked against you. And currency brokers are happy to lend investors lots of money to magnify their bets - way more than they can legally lend to stock investors - so small mistakes explode into catastrophic losses.
What happens when you use 50-to-1 leverage and a currency moves 30% overnight?
It's like soaking your money in napalm and lighting a match.
So why do people keep trading currencies?
I don't know. Why do they keep smoking cigarettes while playing slot machines? Some people just have an affinity for self-destructive behaviour.
A Citi survey last year showed 84% of currency traders think they will be able to earn positive returns every month. Reality shows about 90% of them will be wrong.
I don't trade currency. Does the Swiss move affect me?
Do you pay your mortgage in Swiss francs? Does your boss pay you in euros? Are you planning on travelling to Geneva any time soon? If so, yes. If not, then probably not.
Learn from others' mistakes and move on.
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Morgan Housel is a Motley Fool columnist. You can follow The Motley Fool on Twitter @TheMotleyFoolAu. The Motley Fool's purpose is to educate, amuse and enrich investors. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.
