Q: What does the word “churn” mean in the financial world?
A: The word churn might conjure images of dairy farms and milkmaids, but there’s another kind of churning — it’s financial, and it can hurt you.
That kind of churning is when financial professionals engage in excessive trading (buying and selling) ostensibly on someone’s behalf, often generating commissions for them and usually not serving their clients very well. This churning results in billions of dollars lost each year.
Many stockbrokers are paid based on the number of trades they make in your account, not how well that account performs.
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Even if your broker is good and has you invested in growing companies, the broker might still be moving you out of one good company and into another too frequently. Each transaction results in a gain for the brokerage — regardless of how it fares for you.
Churning is also a problem in the mutual-fund industry. Fund managers are often 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 frequently have what is called a high “turnover rate.” Unsurprisingly, funds with the highest turnover rates tend to underperform their less-active counterparts. After all, lots of buying and selling generates lots of commission expenses, which are borne by shareholders.
And individual investors often churn, too. Investors who churn are hurt not only by 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 approach 40 percent. So selling appreciated stock before you need to or should can cost you more.