Churning

Churning is an illegal and unethical practice where a broker engages in excessive trading in a client's account primarily to generate commissions for themselves, rather than to benefit the client. Think of it as a financial advisor putting their own paycheck ahead of your financial well-being. This activity is a blatant violation of the broker's fiduciary duty to act in their client's best interest. Churning is particularly dangerous in accounts where the broker has trading authority, known as a discretionary account, as they can make trades without needing the client's approval for each transaction. This constant buying and selling not only racks up huge transaction costs that eat away at an investor's principal but also goes against the very grain of sensible, long-term investing. It’s the financial equivalent of a mechanic repeatedly taking apart and reassembling your car's engine just to bill you for the labor.

From a value investing perspective, churning is a cardinal sin. Value investors, following in the footsteps of legends like Warren Buffett and Benjamin Graham, believe that wealth is built through patience, discipline, and holding high-quality businesses for the long term. They treat buying a stock as buying a piece of a business, not a lottery ticket to be flipped tomorrow. Churning is the polar opposite of this philosophy. It treats securities as mere trading chips in a high-stakes game where the only guaranteed winner is the person charging the fees. The damage is twofold:

• Erosion of Capital: Every trade incurs costs—commissions, 'bid-ask spreads', and other fees. When trades are frequent and unnecessary, these costs compound, acting like a persistent leak in your investment portfolio. Your capital is drained away, making it nearly impossible to achieve meaningful growth.
• Tax Inefficiency: Frequent selling of assets held for less than a year often triggers 'short-term capital gains tax', which is typically taxed at a much higher rate than 'long-term capital gains'. Churning can therefore create a significant and completely avoidable tax burden for the investor.

Churning can be subtle, but the signs are there if you know what to look for. Being an active participant in your financial life is your best defense. Don't just file away your account statements—read them!

If you notice any of the following, it's time to ask your broker some hard questions:

• Frenzied Activity: Your account shows a high volume of trades that doesn't seem to align with your stated investment strategy (e.g., a “buy and hold” retirement account seeing multiple trades per month).
• High Turnover: Look for a high 'turnover ratio'. While there's no single magic number, a ratio over 100% (meaning the entire value of your portfolio has been bought and sold within a year) in a standard account is a major red flag. For a conservative, long-term account, even 20-30% can be suspicious.
• Unsuitable Investments: You see trades involving 'options', 'penny stocks', or other speculative securities that don't match your agreed-upon 'risk tolerance'.
• In-and-Out Trading: The broker frequently buys a security and sells it a short time later, often to buy a very similar one. This “musical chairs” approach rarely benefits you but always generates a commission.
• Mysterious Losses: Your account is consistently losing money or underperforming the market, even in good times, and you notice high fees or commission charges on your statements.

The best defense against churning is a good offense. Take control of your financial destiny and build a relationship with your advisor that is based on trust and aligned interests, not just transactions.

1. Set Clear Goals: From day one, be explicit with your advisor about your financial goals, time horizon, and risk tolerance. Put it in writing if possible. The more specific you are, the harder it is for a broker to justify trades that deviate from your plan.
2. Read Your Statements: We can't stress this enough. Read every single trade confirmation and monthly statement. Question any transaction you don't understand or didn't authorize (in a non-discretionary account).
3. Consider a Fee-Based Advisor: Instead of a commission-based broker, consider hiring a fee-only financial advisor. These professionals typically charge a flat fee or a small percentage of your 'assets under management (AUM)'. Their incentive is to grow your portfolio, not to trade it. This simple change in the payment structure can align their interests directly with yours.
4. Know Your Rights: In the U.S., the 'Financial Industry Regulatory Authority (FINRA)' sets the rules and can be a place to file a complaint. In Europe, protections are overseen by the 'European Securities and Markets Authority (ESMA)' and national regulators. If you suspect churning, don't hesitate to seek a second opinion and report the activity. Your capital is hard-earned; don't let anyone gamble with it for their own gain.