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Watch out for churning
Excessive trading can be an investor’s worst nightmare. Montana State Auditor John Morrison tells the tale of a couple in Helena who turned their seven-figure blue chip portfolio over to Ryan Beck & Co., a Florham Park, N.J., brokerage house. Over the next three years, brokers there completed 2,480 trades in the account. The firm pocketed $800,000 in commissions, and the couple lost $1,000,000.
Indeed, NASD’s rule acknowledges that “there are no specific standards to measure excessiveness of activity in customer accounts because this must be related to the objectives and financial situation of the customer involved.”
Here’s how to tell if you’re being churned by your broker. One of the easiest-to-spot red flags is a pattern of buying, selling, and re-buying the same securities over and over again. But also look at the over-all turnover for your account. Divide the total dollar amount of stock purchases for a given period by the average equity. If your account has a turnover rate of more than three times annually, excessive trading may be the reason.
Another sign: a high cost-maintenance ratio. Tally up the equity from each month’s brokerage statement (the amount you would receive if you sold off all securities at that point), then divide by 12 for the average equity of your account for the year.
Next, add up all the brokerage commissions and other trading charges for the year, and compare those two numbers. If that ratio —your cost-maintenance factor —is 10%, your account will have to realize a gain of 10%for the year for you to simply break even.
SEC uses an unwritten 3%ratio as a warning sign of possible churning. Unless you’re a high-octane active stock trader, a cost-maintenance factor greater than 3% could be an indication of trouble.
A common example: Lucent, one of the 30 Dow Industrials. LU sold for $82.22 a share on Dec. 20, 2000. The recent price was $2.33 (Oct. 13, 2006). Ask an LU owner how long the stock must be held since December 2000 just to break even.
William O’Neil, an investment guru and publisher of Investor’s Business Daily (investors.com), says it’s better to sell losing positions quickly (e.g., when a loss stands at 8%) and to ride through a bear market in cash rather than as a buy-and-hold devotee.
Where else to learn more about churning: