Churning is a term used in two different contexts within finance and investing:
- Brokerage account churning: In this context, churning refers to the unethical and illegal practice of a financial advisor or broker who excessively trades securities in a client’s account to generate higher commissions for themselves, rather than acting in the best interest of the client. This excessive trading activity often leads to increased transaction costs, taxes, and potential losses for the investor, while providing little or no benefit in terms of portfolio performance. Churning is a violation of securities regulations, and brokers engaging in this practice can face penalties, fines, or even loss of their license.
- Portfolio churning: In the context of investment management, churning refers to the excessive buying and selling of securities within a portfolio, often driven by a short-term trading mindset rather than a long-term investment strategy. This frequent trading activity can result in higher transaction costs, taxes, and potential underperformance, as it may not allow the investments to realize their full potential over the long term. Portfolio churning is generally considered a poor investment practice, as it can erode the investor’s returns and increase the risk profile of the portfolio.
It is essential for investors to be aware of churning and to monitor their accounts for excessive trading activity. If they suspect churning, they should discuss their concerns with their financial advisor or broker and consider filing a complaint with the appropriate regulatory authorities if necessary.
Example of Churning
Let’s consider an example of brokerage account churning.
Imagine an investor, Sarah, who has an investment account managed by a financial advisor, Tom. Tom’s compensation is based on the commissions generated from trading securities in Sarah’s account. In order to maximize his commissions, Tom starts to engage in excessive trading activity, frequently buying and selling securities in Sarah’s account even when it is not necessary or beneficial to her investment objectives.
Over a period of several months, Sarah notices that her account statements show a high level of trading activity and her account’s overall performance has not improved. In fact, her returns are lower than expected due to the increased transaction costs and taxes resulting from Tom’s excessive trading.
Upon further investigation, Sarah realizes that Tom has been churning her account to generate higher commissions for himself, rather than acting in her best interest. This realization leads Sarah to confront Tom about the excessive trading and potentially report him to the appropriate regulatory authorities for engaging in this unethical and illegal practice.
In this example, Tom’s churning of Sarah’s account resulted in higher costs, lower returns, and potentially damaged trust between the investor and the financial advisor. It highlights the importance of investors being vigilant and monitoring their accounts for signs of churning, as well as working with financial advisors who prioritize their clients’ best interests.