Cost Basis Helps Determine Performance…Incorrectly

Transcript

Almost every investor I know can’t help but check to see how their individual investments are doing from time to time. Some do it way more frequently than others, but pretty much all of us want to know if what we invested in has made us any money, and if so, how much. One common way people do this is by looking at their statements or logging in to their accounts online and looking at a column that is typically labeled something like “Gain/Loss” and it usually shows a percentage. I can’t even begin to tell you how much this number frustrates me. I spent countless hours over the years explaining what this number actually represents to clients because if you think it indicates your profit or loss on an investment, you’re dead wrong.

Welcome to the first season of Invested Poorly: Sad Tales of FInancial Fails, a short-form podcast designed to help everyday investors make wiser investment decisions by learning what NOT to do with their money. Host Jeff Harrell shares timeless stories from his former life as a financial advisor, about the poor—and irrational—choices he witnessed investors make that disrupted their journey to financial independence, or FI. Your ability to recognize, and avoid, similar mistakes could make all the difference for you along your path to reach FI.

Check out the “Introduction” episode for more background on Jeff, why he created this podcast, and how it can guide you to becoming the hero of your own investing story. Now, on with show.

My guess is right now you are shaking your head, asking yourself:  if the gain/loss column doesn’t show me my profit or loss, then what the heck is it? The best way to answer this question would be to simply add two words to it. “Unrealized” and “taxable.” The column should be called your “unrealized taxable gain/loss” because what it illustrates is the cost basis of your investment, compared to the current value, to determine the percentage of gain or loss. I totally get it, you’re still probably confused as to how this is any different than what you thought it was. The reason you’re confused is because cost basis doesn’t mean what you think it means; cost basis does not equal how much cash you’ve invested in the security.

Stay with me on this topic. I know it’s a little technical, but I believe it is a very important concept for the average investor to understand. I received numerous phone calls over the years from clients questioning the performance of their accounts because of this cost basis number. It is crucial you understand that the longer you have held a security and the more trading you do in it, like buys and sells, the more misleading the cost basis number can be. This lack of understanding was very often the reason clients wanted to make changes to their accounts. They basically thought their investments were performing worse than they really were.

So, what the heck is cost basis, if it isn’t the amount of cash you have invested in a security? First, if you only remember one thing after listening to this episode, it’s that cost basis should actually be called tax basis. Because it represents the dollar value of a security that will be subtracted from the proceeds when a security is sold to determine the taxable gain or loss. For example, if you have a security with a cost basis of $10,000, and it is worth $15,000, you will have a taxable gain of $5,000 that you have to pay tax on when you sell that security. But let’s take a step back and see where that $10,000 of cost basis might have come from.

The first, and probably most common scenario, involves reinvesting dividends. When you reinvest dividends into a security, your cost basis goes up every time this happens. This is to prevent you from paying tax twice because even though you reinvested the dividend, it still is a taxable event. Thus, you will count the dividend as income in the year it was realized, and your cost basis is increased to account for the fact that you have already paid tax on that amount.

So back to our $10,000 example, it is very possible that someone could have invested $8,000 into a security and over the years accumulated $2,000 of reinvested dividends, resulting in a cost basis of $10,000. When they go to sell the security, they will realize the $5,000 gain as described in the example, but you have to recognize that $2,000 of the cost basis was actually dividends, which are profits from the investment. So in this scenario, the dividends plus the taxable gain of $5,000 indicate a real profit of $7,000. If you were simply looking at that $5,000 or 50% gain I used in the example, you are understating it by $2,000. The correct percentage gain would actually be 87.5% on the original $8,000 investment. That is a pretty big difference if you ask me… Misleading?? I think so.

Here’s another example.  Let’s keep the same initial assumption; your statement shows a cost basis of $10,000 and the security is worth $15,000 today. However, in this second example, let’s assume you received $2,000 of dividends over the years, but they were not reinvested. This time you would have invested $10,000 to start and accumulated $2,000 of dividends. Now the security is worth $15,000, so you have the same $5,000 or 50% gain in the first example. But what about those dividends? Do they not count? Your darn right they do, so this time your gain is $7,000 or a 70% profit on the original $10,000 investment.

Once again, the gain/loss column understated the real investment return because the security pays dividends. So here’s the takeaway: the more dividends the investment pays, the greater the understatement of the gain/loss. This is typically why fixed income securities and high dividend paying stocks and bond funds or ETFs are misrepresented the most. In fact, it is not uncommon for a fixed income investment to be held for years and show very little gain, or possibly even losses, from a cost basis standpoint even though it probably has made a nice profit.

Here's another instance of how cost basis can be misleading. This happens when you buy and sell a security several times because you now have multiple purchase prices to deal with. So when you go to make a sell you have to offset the sale against a specific purchase. Hopefully, this next example will clarify what I’m talking about.

Let’s say you bought 100 shares of a stock three separate times, once at $10, once at $15, and once at $20; your average cost is $15 in this example. Now let’s say you decide to sell 100 shares. If you pick the ones at $10 to sell, your cost basis will be an average of the remaining two, or $17.50, because you got rid of the $10 shares. If, however, you decide you want to sell the $20 shares, your cost basis is now $12.50, the average of the remaining $10 and $15 shares. If the stock is trading at $15 a share, you could see a gain or loss, based solely on which shares you decided to sell.

Most of the time it’s advantageous for tax purposes to use the highest cost purchases for the sale proceeds, leaving the lower cost shares still in your account. If you’ve been selling off your high-cost shares of a security, I’d argue the gain/loss percentage overstates your performance because you are holding on to your best performing shares and selling off the higher cost ones. I know the math on this is a little complicated, but I hope these examples make it perfectly clear why cost basis should actually be called tax basis.

Ultimately, this is a rabbit hole you could go down in so many ways that I’m just going to leave it here. I’ll let you decide if you need to investigate further to make sure you have a full understanding of how misleading cost basis can be. As my inquisitive little nephew says, “search it up” to find more information about how misleading cost basis can be. You can also check out the description of this episode to find an article Vanguard wrote on this subject.

I think it’s safe to assume many of you listening didn’t fully understand cost basis and the gain/loss column before this episode. Hopefully, I have clarified cost basis a little bit, but now you are probably wondering, how the heck do I determine the performance of a security I’ve invested in or maybe even the overall performance of my accounts?
Well, with respect to individual security performance, my preferred method to use is Morningstar.com. You can type in any symbol and then click on the performance tab. It will take you to a page on Morningstar’s website that shows you all relevant trailing returns and, even better, compares them to relevant indexes so you can evaluate the performance. 

As for the overall performance of your accounts, be sure to check out episode 5 where I discuss measuring performance in greater detail. This episode will probably give you a whole new perspective of what account performance really represents.

I sure hope you enjoyed this episode of Invested Poorly and will be able to take something from it to improve your decision making as you navigate the twists and turns of your personal investing adventure. Be sure to check out my website at AreYouFI.com (that’s A R E Y O U F I dot com) where you can find resources and show notes with the charts and graphs I mention during the episodes. These are like little treasure maps that can help you choose more wisely along your quest to reach FI, or financial independence.

Never forget, in the short-term the stock market is unpredictable, and as my mischievous little nephew likes to say, “things just happen”! So focus on the long-term, by controlling your emotions, simplify your investments, and always… ignore the noise.

I’m your host, Jeff Harrell.  Thanks for listening.

Invested Poorly: Sad Tales of FInancial Fails was created for informational purposes only and should not be relied on for specific tax, legal, or investment advice. You should consider consulting a qualified professional to review your situation before engaging in any transactions. Investing involves risk, including loss of principal and past performance is no guarantee of future results. 

This podcast was produced by Ted Cragg. Learn more about creating podcast mini-series like this by visiting QuickEditPodcasts.com.