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How Does Portfolio Churning Affect Your Returns?

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Not all stocks are winners. It's a sad truth. Some stocks are big winners in a shorter period of time than you expect. While value investing intends to reduce the amount of daily or weekly oversight you exercise over your portfolio, you still need to pay attention to what's going in with your stocks.

Infrequent and careful portfolio rebalancing can improve your potential returns and minimize your investment portfolio risk. If done too often—done without care—it can be stock churning, which can cost you money in real dollars now and thousands of dollars later.

What is Portfolio Churning?

What is churning? Simply put, it's the rate of turnover of your investments.

As you know, many portfolio managers and stock brokers make money by executing trades for you. The more trades they make, the more they make in commissions. The Securities and Exchange Commission regulates these activities. Per the SEC's definition, illegal portfolio churning is excessive buying and selling of client investments in order to generate commissions.

That may not apply to you. (If it does, contact the SEC to file a formal complaint.) If you're reading this, you're probably interested in managing your own stocks—and you're less exposed to that risk!

While the SEC's definition of churn is very specific for legal oversight of positions with the professional duty to manage money for other people, the concept itself is a useful measurement for how often your investment positions change. Like other measurements and metrics, maximizing or minimizing churning on its own isn't the goal; the goal is still to provide a good return at an acceptable level of safety with modest effort.

Portfolio Turnover Ratio

Some analysts review mutual funds by how much value (in money) changes positions (securities held) in a given year. This portfolio turnover ratio divides either the total sales or purchase transactions in a year by the average net assets of the fund. If you have a million dollars in a mutual fund and the manager performed $500,000 in sales for the calendar year, your ratio is 50. If all of the dollars in the fund changed stock positions in the year, your ratio is 100.

You may also hear this called the stock market turnover ratio—same definition!

There's no single correct ratio. There's no single acceptable churn rate. The amount of turnover depends on the volatility of the market as a whole (volatile markets often present more opportunities to buy and sell), the investment goals of the fund or the portfolio (short term versus long term), and even the success of the investment manager. That latter point is subtle. Just because a million dollar portfolio had a million dollars in sales in one calendar year doesn't mean that every position was bought or sold during that year. It could be that a handful of $100,000 investments were modest short-term successes and added up to that million dollars of sales.

The Downsides of Portfolio Churn

The immediate effects of portfolio churn are easy to understand. If every trade costs you money in commissions, minimizing unnecessary trades will save you money. Likewise, if every trade may incur taxation (especially short-term capital gains taxes), minimizing unnecessary trades will reduce the money you pay in taxes. Every tax or commission you pay cuts into the profit you make and the money you can reinvest to work harder for you in the future.

Those aren't reasons to avoid trading altogether, though the advice of Warren Buffett and John Bogle to novice investors applies: Buy the S&P 500 index fund, hold it forever, and sleep soundly at night. These are reasons to minimize unnecessary churn. By all means, make sensible trades. Buy undervalued stocks. Sell stocks that won't perform or which have given you the profit you expect and which won't give you that profit in the future. Sell stocks in favor of better opportunities.

Short-Term Thinking and Investment Churn

The worst part of high portfolio churn is the underlying philosophy. It's easy to fall into the trap of thinking in terms of months and quarters, not years and decades. This is a pernicious problem for fund managers, who get evaluated on a quarterly and yearly basis. (Some—not much—pity to them, as they have to placate multiple clients with widely varying investment goals.) You know exactly what your goals are and can craft a strategy for yourself.

If you have the pressure to deliver consistent 3-5% growth, quarter after quarter (beating the market handily every year, after taxes, fees, and inflation), you don't have the luxury of buying an undervalued stock and waiting for it to take off. That might take years, and you'll get pressure starting in December.

If every mutual fund manager behaved this way and judged the performance of individual stocks on quarterly results, that's billions of dollars. That's a lot of stock prices affected by buying and selling. If the corporate officers and boards of those companies have their own bonuses affected by stock prices, wouldn't they start to make short term decisions on their own?

A little unnecessary buying and selling of your own stocks isn't responsible for risk in the global economy. Yet this extra volatility does give value investors like us (small in comparison to the big fish) extra opportunities to buy good stocks at great prices, hold them while they make sense, and build real wealth over the long term.

Buy and sell when it's appropriate. Avoid unnecessary transactions. Take the long view. Don't let the quest for the perfect keep you from reasonable and even great returns now. Resist the temptation of short-term thinking. Your portfolio will thank you for it.