What is Considered Excessive Trading? Protect Your Brokerage Account from Churning

Have you ever looked at your brokerage statements and wondered if there’s too much activity going on? Maybe you’re concerned about all those transaction fees adding up. Well, you’re right to be cautious! Excessive trading (sometimes called “churning”) can seriously damage your investment returns over time. Let’s dive into what this problematic practice is all about.

Understanding Excessive Trading: The Basics

Excessive trading occurs when a financial professional recommends a level and type of trading activity that doesn’t align with your investment goals, risk tolerance, and financial circumstances. In more serious cases where there’s an intent to defraud or reckless disregard for your interests, it crosses into “churning” territory – which is actually considered securities fraud.

Why should you care? Because every trade costs you money – in commissions, fees, and other expenses When these pile up, they can significantly eat into your investment returns

As FINRA (Financial Industry Regulatory Authority) explains excessive trading happens when your broker makes recommendations that

• Don’t match your stated investment objectives
• Exceed your risk tolerance
• Ignore your financial situation

How Brokerages Define Excessive Trading

Different brokerages have their own policies regarding what constitutes excessive trading. Let’s look at Fidelity’s approach as an example:

Fidelity monitors what they call “roundtrip transactions” – when you purchase a mutual fund and then sell it within 30 calendar days. For example, if you buy a fund on May 1 and sell it before May 31, that counts as a roundtrip

Their policy includes several key elements:

• Fund Level Blocks: If you make two roundtrip transactions in the same fund within 90 days, you’ll be blocked from making additional purchases in that fund for 85 days.
• Complex-wide Blocks: If you make four roundtrip transactions across any Fidelity funds within a 12-month period, you’ll be blocked from purchasing any Fidelity fund (except money market funds) for 85 days.
• For repeat offenders, Fidelity might impose long-term or permanent purchase blocks.

Some transactions are exempt from these rules, including:

• Trades under $25,000
• Money market fund transactions
• Dividend and capital gain reinvestments sold within 30 days
• Automatic investment or withdrawal orders

Warning Signs of Excessive Trading

How can you tell if your account might be experiencing excessive trading? Here are some red flags to watch for:

1. Unauthorized Trading

Notice trades in your account that you never approved? This is a serious issue! Always keep notes about trades you’ve approved and notify your broker immediately if you see unauthorized activity.

2. High Volume or In-And-Out Trading

Even if your investment strategy is aggressive, frequent transactions aren’t always in your best interest. Be particularly wary of:

• Buying and selling the same securities within short timeframes
• Repeatedly selling your portfolio and reinvesting the proceeds
• The “in-and-out” pattern where new securities are quickly sold after purchase

3. Unusually High Fees or Commissions

If the total amount you’re paying in fees seems high, or if one part of your portfolio consistently generates higher fees than others, this could indicate excessive trading. Remember that account statements don’t always show every fee, so don’t hesitate to ask for a complete breakdown.

The Three Rs: Questions to Ask Your Broker

If you suspect excessive trading, ask your financial professional about the three Rs:

1. Rationale: What’s the reasoning behind the recommended trading activity? How does it align with your investment objectives and risk tolerance?

2. Reasonable Fees: Are the total commissions and fees reasonable? Ask for a detailed explanation of all charges, including markups and margin interest costs.

3. Return: What percentage return would you need just to break even after all these fees? This helps you determine if commissions are consuming too much of your investment gains.

An important point to remember: excessive trading can occur even when your account balance is growing. The question is whether your returns would be higher with a more appropriate trading strategy.

The Real Cost of Excessive Trading

Let’s get real about why excessive trading is so problematic. Here’s what it does to your investments:

1. Reduces Returns: Trading costs like commissions and fees directly subtract from your investment returns.

2. Increases Taxes: Frequent buying and selling can create taxable events, leading to higher tax bills.

3. Disrupts Portfolio Management: As Fidelity points out, excessive trading can force “untimely and unwanted buying and selling of portfolio securities,” disrupting investment strategies.

4. Creates Psychological Pressure: Constant trading can cause anxiety and lead to poor decision-making based on short-term market movements rather than long-term goals.

How Brokerage Firms Monitor Excessive Trading

Brokerage firms have a responsibility to supervise customer accounts for signs of excessive trading. They employ various monitoring methods:

• Transaction Monitoring: Systems that flag accounts with unusually high trading frequency
• Account Reviews: Periodic reviews of accounts showing high activity levels
• Customer Notifications: Some firms will contact you if they detect potential excessive trading

If your firm sends you a letter about trading activity in your account, don’t ignore it! This is an opportunity to review what’s happening and address any concerns.

How to Protect Yourself from Excessive Trading

Here are concrete steps you can take to protect your investments:

1. Review Account Documents Carefully

When opening an account, carefully verify the information – especially questions about risk tolerance and investment objectives. If anything doesn’t match what you communicated to your broker, contact them immediately.

2. Monitor Account Activity Religiously

• Review every trade confirmation as it arrives
• Check monthly/quarterly statements thoroughly
• Compare activity with your investment strategy
• Track the fees and commissions you’re paying

3. Document Everything

Keep records of:

• All discussions with your broker
• Trade approvals you’ve given
• Questions you’ve asked and answers received
• Any concerns you’ve raised

4. Know Your Investment Strategy

Have a clear understanding of:

• Your investment goals
• Your risk tolerance
• Appropriate trading frequency for your situation
• Reasonable fee levels for your account type

Where to Turn for Help

If you’ve addressed concerns with your financial professional and aren’t satisfied with the response, here are your next steps:

1. Escalate Within the Firm: Contact a manager or the firm’s compliance department, preferably in writing.

2. File a Complaint: If necessary, file a complaint with FINRA or submit a complaint to the SEC.

3. Seek Expert Help: For questions or concerns, especially for seniors, call the FINRA Securities Helpline for Seniors at 844-574-3577 (Monday-Friday, 9 a.m. – 5 p.m. Eastern Time).

Different Types of Excessive Trading

Let’s look at some specific patterns that might indicate excessive trading:

Pattern #1: Churning

This involves trading solely to generate commissions with little regard for the investor’s goals. It typically shows up as frequent buying and selling with no clear investment strategy.

Pattern #2: Cost-to-Equity Ratio Problems

If the annual cost of maintaining your portfolio (in fees and commissions) exceeds a reasonable percentage of your account value (typically 2-3%), this could indicate excessive trading.

Pattern #3: In-and-Out Trading

Repeatedly buying securities and selling them shortly afterward without a clear strategic reason is a major red flag.

Pattern #4: Switching

Selling one mutual fund to buy another similar fund without clear investment advantages is often just a way to generate additional commissions.

Why Do Brokers Engage in Excessive Trading?

Understanding the motivations behind excessive trading can help you protect yourself:

1. Commission-Based Compensation: Brokers who earn transaction-based compensation have a financial incentive to encourage more trading.

2. Sales Quotas: Some firms set transaction or revenue targets for their brokers.

3. Misaligned Incentives: Without proper supervision, the broker’s financial interests may conflict with your investment goals.

4. Poor Training or Ethics: Some brokers simply don’t understand or don’t respect their fiduciary responsibilities.

Is Your Trading Strategy Appropriate?

Not all frequent trading is inappropriate. Here’s how to tell if your trading activity makes sense:

The key is whether the trading activity aligns with YOUR goals and tolerance for risk. A strategy that’s perfect for someone else might be totally inappropriate for you.

Final Thoughts: Finding the Right Balance

Finding the right balance between too much and too little trading activity is essential for investment success. While excessive trading can drain your returns through fees and potentially poor decision-making, too little activity might mean missed opportunities to rebalance or adjust to changing market conditions.

We believe the best approach is to:

• Clearly communicate your investment objectives
• Understand all fees and commissions
• Regularly review account activity
• Question anything that seems excessive
• Work with financial professionals who prioritize your interests

By staying vigilant and asking the right questions, you can help ensure that your investment account works for you – not just for your broker’s commission schedule.

Remember, most financial professionals are ethical and work hard to help their clients succeed. But it’s always wise to verify that the activity in your account serves YOUR financial goals, not someone else’s.

The 3-5-7 rule is a risk management strategy in trading that sets guidelines for exposure and profit. It recommends risking no more than 3% of your capital on a single trade, limiting total risk across all open positions to 5% of your capital, and aiming for a minimum profit target of 7% on winning trades, often implying a high risk-reward ratio.