Churning and Excessive Trading Erode the Profitability of an Investment Account

While some investors choose to develop an investment portfolio because they enjoy the challenge of navigating the ups and downs of the stock market, others rely on theirs for financial growth and future security. And even though financial advisors typically tend to the day-to-day handling of customer accounts with the clients’ best interests in mind, there are some occasions where investors may be the victims of excessive trading, also called churning. This kind of trading activity not only violates FINRA rules, which investment advisors and their member firms are legally obligated to adhere to, but it also eats away at the profitability of customers’ investment accounts.

What is Churning?
When investment advisors buy and sell securities excessively to generate greater profits through commissions, it’s commonly referred to as churning. This kind of illegal and unethical activity violates FINRA’s suitability rules, which state that investment advisors are to make trades that fit their clients’ financial goals, risk tolerance, and similar parameters. What ends up happening is that investment advisors’ commissions offset any growth, and investors end up losing money even when their portfolios are profitable. The chosen investments need to perform at a higher rate of return to overcome the financial advisor’s commissions plus any account fees and applicable taxes.

How Can Churning Be Identified?
While the high turnover of securities and high cost-to-equity ratios in a customer account may be a sign of churning, there are other red flags to be aware of, including consideration of whether a trade’s potential for profitability is greater than its cost.

Another sign of churning is a repeated cycle of trades. This produces commissions for the investment advisor but does not overall change the value of your portfolio. For example, if the same ten shares of a widget manufacturer are bought and sold 100 times, your portfolio isn’t likely to grow but your broker just made commissions on all 100 of those transactions. Excessive trades may also be concentrated on high-commission products for maximum profit to the financial advisor and broker-dealer.

How Churning Hurts Your Investment Account
It’s investors who are harmed the most by the practice of churning. At their most basic level, these trades are not aligned with the customer’s investment goals. When advisors make decisions about buying and selling securities that place their own needs first, they’re potentially letting prime growth opportunities for their clients slip away.

Excessive trading also generates higher commissions and account fees on investors’ portfolios. These trades benefit the financial advisor and brokerage more than the customer because of the commissions, fees, and other expenses charged; these may eat into any profit gained by the buying and selling of these securities. Each trade comes with these added expenses as the cost of doing business; however, when more trades are made than necessary, what once seemed like reasonable commissions and fees add up quickly. Tax liabilities can increase just as quickly. When a portfolio is being churned, the selected investments need to produce even greater rates of return to cover the expenses of commissions, fees, and taxes.

What You Can Do to Fight Churning
One of the best ways that investors can take action to prevent churning in their accounts is to stay aware of all activity in their portfolios and maintain the appropriate perspective. After all, investment advisors, by and large, are professionals. Brokers are expected to adhere to FINRA and SEC rules for legal and ethical trading; in addition, member firms have an obligation to supervise brokers to help identify potential churning. It’s not so much the day-to-day buying and selling that’s going to be a warning sign as much as long-term trends. Percent changes are typically reviewed on an annual basis when determining whether churn is happening.

That being said, it’s important to recognize if the pace of transactions in your accounts has changed recently. This may be in response to favorable market conditions or it may be a sign of excessive trading. Do all of these purchases and sales fit your goals? Has your tax liability increased suddenly without a commensurate increase in your profits? These can be important questions to ask yourself and your investment advisor if you have concerns about how the trading activity is affecting the performance of your portfolio. Consult with the broker-dealer and FINRA in filing a complaint if necessary, and realize that you may have legal recourse, too. Excessive trading isn’t just unethical, it’s illegal.

The Wolper Law Firm, P.A. represents investors nationwide in securities litigation and arbitration on a contingency fee basis. Matt Wolper, the Managing Principal of the Wolper Law Firm, P.A., is a trial lawyer who has handled hundreds of securities cases during his career involving a wide range of products, strategies and securities. Prior to representing investors, he was a partner with a national law firm, where he represented some of the largest banks and brokerage firms in the world in securities matters. We can be reached at 800.931.8452 or by email at mwolper@wolperlawfirm.com.

Attorney Matthew Wolper

Attorney Matthew WolperMatt Wolper is a trial lawyer who focuses exclusively on securities litigation and arbitration. Mr. Wolper has handled hundreds of securities matters nationwide before the Financial Industry Regulatory Authority (FINRA), American Arbitration Association (“AAA”), JAMS, and in state and federal court. Mr. Wolper has handled and tried cases involving complex financial products and strategies ranging from traditional stocks and bonds to options, margin and other securities-based lending products, closed/open-end mutual funds, structured products, hedge funds, and penny stocks. [Attorney Bio]