Excessive trading, sometimes called churning occurs when a financial advisor, exercising control over an investor’s account engages in transactions which are excessive in size and scope to the needs and objectives of the client for the purpose of generating commissions.
Churning generally occurs in accounts where the financial advisor has discretionary authority, or authorization to make transactions without first consulting with the client. Excessive trading also occurs in accounts where a client does not follow the trading closely. This gives unethical financial advisors the opportunity to make unnecessary and inappropriate transactions.
A rule of thumb to measure churning is the generally accepted “Six Times Turnover” Rule. If an account’s equity has been turned over six times in the course of a year, with the financial advisor making all or most of the transactions, there is a presumption the account has been churned. Put plainly, if an account is worth, on average, $100,000 over the course of the year, and $600,000 in purchases were made on that $100,000 net equity (not counting margin) then the account turnover rate would be 6X: $600,000 /$100,000.
Another valuable tool to determine whether an account was churned is the cost to equity ratio. Using the same $100,000 account value, determine the amount of commissions and margin interest charged. Say commissions are $10,000 and margin interest is $1,000. The total is $11,000. Divide $11,000 by $100,000 to arrive at an 11% cost to equity ratio. In other words, the account would have to generate an 11% return just to break even. By any objective measure, this is excessive.
You can prevent excessive trading by always opening your mail from the financial advisor and closely reviewing the monthly statements for signs of trades you did not approve.