Look up the word "churn" in your Merriam-Webster dictionary, and you'll find three definitions. The first two should be familiar: (1) "to agitate (milk or cream) in a churn to make butter" and (2) "to stir or agitate violently, to make (as foam) by so doing." The third is one that we at the Fool like to point out to people: (3) "to make (the account of a client) excessively active by frequent purchases and sales, primarily to generate commissions."
In other words, 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, for both stockbrokers and mutual fund managers, and as a result, the portfolios of individual investors can suffer. Billions of dollars are lost each year 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. Even if your broker is good, and has your money invested in growing companies, he or 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 each year that they can't simply be patient with solid investments that are temporarily doing poorly. Mutual funds that repeatedly buy and sell have what's 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 averages.
Commissions aren't the only things hurting the churned investor. Consider taxes. Any stocks you've held for more than a year get taxed at the preferable long-term capital gains rate, which is 15% for most people. Short-term gains are taxed at your ordinary income tax rate, which can top 30% -- twice as much as long-term capital gains taxes. If your account or fund is being churned, you're probably paying more in capital gains taxes than you'd want to.
A few minutes in our Broker Center may help you find a brokerage that will serve your needs better and cost you less than your current brokerage. This article on finding the right brokerage may be helpful. Indeed, some very reputable brokerages now charge commissions of $5 or less per trade. (Our comparison table may be particularly helpful.)
This article has been updated by Foolish research associate Katrina Chan and was originally published on July 12, 2006 by Selena Maranjian.