A Bad Kind of Churning
Churning doesn’t just refer to the production of butter. It’s also a financial term, referring to when financial professionals engage in excessive trading — buying and selling securities. They typically do so on behalf of their clients, generating commissions for themselves in the process — and usually not serving those clients well. This churning results in billions of dollars lost each year.
The problem exists because some stockbrokers are paid based on the number of trades they make in your account, not how well that account performs. (This explains brokers who cold-call you, trying to sell you on supposedly terrific investments.) Even if your broker is good and has you invested in growing companies, he or she might still be frequently moving you out of one good company and into another. Each transaction can result in a gain for the brokerage — regardless of how it does for you.
Study the statements you receive from any money managers to see how often they’re placing trades. Remember that big bucks are typically made in great stocks when you hold on for many years.
Churning is also a problem in the mutual fund industry, where fund managers can be so pressured to beat the market over short periods that they can’t afford to be patient with solid holdings that just need more time to perform. A fund with a high “turnover rate” reflects intense trading activity, and funds with the highest turnover rates often underperform their less active counterparts. After all, lots of buying and selling generates lots of commission expenses, which are borne by shareholders.
Churned investors also get a tax hit. Gains from stocks you’ve held for more than a year are taxed at the preferable long-term capital gains rate, which is 15 percent for most people. Short-term gains are taxed at your ordinary income rate, which can be more than twice as much.
Even we individual investors can sometimes engage in churning, if we have short attention spans or are just impatient. Be aware of churning, and aim to avoid it.