Monday, August 6, 2012

What is Cost Basis for Investing?

Last week I was in an interesting discussion about cost basis for dividend investors. How does one calculate cost basis?  You might as well ask what the best ice cream flavor is as it comes down to personal preference.
Now to be clear before I continue... the IRS has a very specific way of calculating cost basis for tax purposes. The following is not about that as you have to follow their definition. This is purely about how do you want to think about your money. How do you define your success...

Quite a bit of theory and math coming up or jump to the bolded section for the short version...

First let's look at a purchase of stock and the total dollar amount generated without terms of cost basis and % returns.
1.0: Buy $10 stock that pays no dividend. Price rises to $20. Total amount: $20
2.0: Buy $10 stock that pays $1 dividend and keep it as cash. Price rises to $20. Total amount: $21
3.0: Buy $10 stock that pays $1 dividend and DRIP an extra 0.1 shares at the same price. 1.1 shares rise to $20 share price. Total amount: $22
Assuming the stock price moved as described then #3 seems to be the clear best choice as it generates the most money. How is it then measured as far as profit and % gain?

If you bought a $10 stock and then one day later you were paid a special $10 dividend the stock would essentially be free to you. You have all your money original money back. The share price could drop to $0 and you wouldn't have lost anything. From this point of view we would actually want to reduce our cost basis by the dividend paid out. Using the same examples as above...
1.1: $10 original purchase goes to $20: 100% return
2.1: $10 original purchase, $1 dividend drops your original at risk money to $9 then goes to $20 for $11 profit: 122% return
3.1: $10 original purchase, $1 dividend drops your original at risk money to $9, you DRIP 0.1 shares, your 1.1 shares rise to $20 for $22 total position and $13 profit: 144% return
This makes sense because that $1 dividend is in your pocket and independent of share price fluctuations so it could be taken out of the equation.

We can look at DRIP shares in another way. That they are a new purchase of stock. That you have the $1 dividend in your pocket and decide to make a new purchase placing more of your money at risk.
1.2: No change: 100% return
2.2: No change: 122% return
3.2: $10 original purchase, $1 dividend drops your original at risk money to $9, you DRIP 0.1 shares raising your at risk money back to $10, your 1.1 shares rise to $20 for $22 total position and $12 profit: 120% return.
From this are we to say that starting with $10 and ending with $21 is more profitable than starting with $10 and ending with $22 because that is what the % profit tells us.
If you feel dizzy or confused here don't worry because...

Stock brokers calculate profit and cost basis differently too
Sharebuilder calculates cost basis that a dividend does not reduce cost basis and DRIP shares increases it.
Fidelity calculates cost basis that a dividend reduces your cost basis and DRIP does not increase it.
I have active accounts with both and turn DRIP on and off at different times for different stock. Its amazing how much more profitable I feel with Fidelity.

% returns and measure of gains are nothing more then a "feel good stat" most often used to figure out who the better investor is between different strategies and different positions. There is utility with how you set your own cost basis and use it to measure yourself to yourself. Was investment choice A better then your investment choice B. I feel it is important to measure yourself to find areas to improve upon so we do need some sort of cost basis to % return metric.

For the Model Portfolio I am using my original purchase as the cost basis. How much of my original money out of my pocket am I risking.
Dividends taken as cash I will use to reduce my cost basis.  This money is out of the market and will not be impacted by share price changes. It is the same as if I never had that money in the market in the first place.
Dividend taken as DRIP I will reduce my cost basis as I took it in cash then put my money from my own pocket back into the market at risk to price fluctuations. Essentially make DRIP investments an even wash.

Disclaimer: The investments and trades in my videos and blog entries are not recommendations for others. I am not a financial planner, financial advisor, accountant, or tax adviser. The financial actions I talk about are for my own portfolio and money and only suited for my own risk tolerance, strategy, and ideas. Copying another person's financial moves can lead to large losses. Each person needs to do their due diligence in researching and planning their own actions in the financial markets.

1 comment:

  1. I believe brokers should do it the PROPER way. Sharebuilder seems right in calculating the cost basis.

    I believe dividends due not decrease your cost basis when you receive them as cash. When calculation total return , dividends increase the return, as it is part of the profit.

    ACB and total return calculations are best done in a spreadsheet. It has to be done a certain way on your tax forms, so I generally do it that.