The Swiss National Bank made history last week, 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 defense, 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 emphasizes 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 needs to be "someone genetically programmed to recognize and avoid serious risks, including those never before encountered."
But come on. Goldman Sachs CFO Harvey Schwartz said this was a like 20-sigma event, meaning, statistically, a move this big should only happen once every 4 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 only occurred 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, according to Forex Magnates.
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 your 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 behaviors.
A Citi survey last year showed 84% of currency traders think they'll 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 at all?
Do you pay your mortgage in Swiss franc? Does your boss pay you in euros? Are you planning on traveling to Geneva anytime soon? If so, yes. If not, then probably not.
Learn from others' mistakes, and move on.
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