- Date : 03/01/2023
- Read: 4 mins
Yes, churning and trading costs and transaction charges in investment accounts can lower profit, ROI, and the benefits of compounding. Learn the way out.
Have you ever noticed that churning and trading costs eat your returns? If yes, consider commissions, brokerages, fees, and other expenses while calculating your return on investment. These costs may seem small when a single or few trades are considered. But they may significantly affect the value of your investment in the long run.
Besides paying high churning costs in your investment account, you pay short-term capital gains tax at 15%. When the profit is reinvested as part of the churning, you pay higher trading costs.
Transaction charges, as well as the churning and trading costs, lower the amount getting reinvested. That's why churning and excessive trading have a high tax impact too. This, in turn, eats away the benefits of compounding.
So, the first thing you must notice is whether the reinvestments generate significantly higher returns than the low-cost options. You'll start feeling the pinch when the churning doesn't produce a high enough return or even a negative return. That's when churning and trading costs start eating into your profits. No matter the outcome, your broker makes money due to churning.
You must be thinking, what's the way out? Before advising how you can identify churning and the ways to fight it, let's first understand what it is in the first place.
Churning and Trading Costs: What are they?
Many financial advisors operate investment accounts for their investors to help them earn more. However, sometimes these advisors, along with their member firms, buy and sell stocks excessively to generate more commissions for profit.
Excessively buying and selling stocks are only sometimes profitable for investors. Excessively trading can make the investors lose money even when the portfolio remains profitable.
You, as an investor, can avoid churning and trading costs only if you actively make decisions regarding your portfolio. But how can you identify whether your investment account is affected by churning? Let’s find out.
How to Identify Whether your Investment Account is Affected by Churning?
There is no quantitative measurement to know whether your investment account is subjected to churning. However, two signs indicate that churning and trading costs affect your profit. These three signs are:
- The high cost-to-equity ratio in your account
- High-security turnover
- A repeated cycle of trades
Always check your portfolio to see whether a trade cycle is increasing your portfolio's overall value. If it's not, but your financial advisor's commission is increasing, it may be a sign of churning.
How to Stop Churning and Trading Costs?
You can prevent churning in your commission-based account by staying aware of all trades in your portfolio. When you closely look at the transactions in your investment account, try to find whether the pace of transactions has recently changed. If you have such a trend, there may be two reasons:
- Favourable market conditions
- Your financial advisor is excessively buying and selling
No matter what the reason is, now check the following
- Do all the trades align with your goals?
- Has excessive trading in your commission-based account led to a sudden increase in tax liability?
- Has your portfolio’s performance improved or remained the same?
You should consult your broker-dealer if you find that by excessively buying and selling stocks:
- Hasn’t increased the value of your portfolio significantly
- Didn’t align with your financial goals
- Increased your tax liability
Ask your financial advisor and broker-dealer to stop such practice. Start making decisions for all trades yourself.
Learn more about reducing your trading costs here.