Churning is a symptom of a flawed system

You may think of churning as how butter is made. But there’s another meaning of the word, and it’s worth learning about, as ignoring it can cost you. As the Merriam-Webster dictionary explains, to churn financially is “to make (the account of a client) excessively active by frequent purchases and sales primarily in order to generate commissions.”

Take a stroll down Wall Street and listen intently, and you might hear the sound of stockbrokers and money managers shaking and shuffling your portfolio. The system is flawed, both for stockbrokers and mutual fund managers, and as a result the portfolios of individual investors can suffer. Billions of dollars are lost each year due to churning.

You see, many stockbrokers are paid based on the number of trades they make in your account, not how well that account performs. (Are you beginning to see why some brokers like to interrupt your dinners with cold calls, trying to get you buy into some “amazing opportunity”?)

Even if your broker is good and has you invested in growing companies, she might still frequently be moving you out of one good company and into another. Each transaction results in a profit for the brokerage — regardless of how it fares for you.

Churning is also a problem in the mutual-fund industry. Fund managers are so pressured to beat the market over short periods that they can’t simply be patient with solid investments that are temporarily doing poorly. Mutual funds that buy and sell often have what is called a high “turnover rate.” It shouldn’t surprise you that the funds with the highest turnover rates are often those that consistently lose to the market.

Finally, we investors ourselves engage in churning, if we have short attention spans and are impatient.

Churned investors are hurt by not only excessive commission costs but also taxes. Any stocks you’ve held for more than a year get 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 as high as 35 percent, more than twice as much.

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