Performance and Cost Basis

Charlie Bowers Finance 101, Insight Investing Articles, Investing, Investing & Planning

Can I determine my stock’s performance based on its cost basis?  I see this given for each stock I own on my monthly Schwab Account Statement.  Performance and cost basis are the same thing, right?  Can’t I use them interchangeably?  

Nope!  Cost basis won’t necessarily tell you how much money you’ve made or your investment’s performance.  It may, however, help you file your taxes.

Let me preach on it!

Let’s look at a stock over a year’s time.  When you receive a dividend from that stock, it is part of the stock’s total return or performance.  But what does that mean relative to the cost basis?  Well, that answer depends on what you do with that dividend.  Are you going to hang on to the cash, or are you going to buy more shares of that stock?

What occurs when the dividend is reinvested is this value is added to your cost basis and you increase the number of shares you own.  And in non-qualified accounts, be thankful that this is the case. Remember that you are taxed on capital gains.  (Value When Sold less the investment’s cost basis).

This is the reason that the cost basis is used when calculating capital gains and losses for tax-filing purposes, and not used as a go-to measure for investment performance.

How About an Example?

An example may be the best way to illustrate the difference between performance and cost basis:

Let’s say you invest $10,000 each in two stocks, and you hold each in a separate account.  One stock is a dividend-payer and one is not.  Each stock’s price is $10 per share.  This means you own 1000 shares of each stock and your cost basis for each is $10,000.

Over the course of the first year, Stock A goes up $1000 because of market gains but does not pay a dividend.  At the end of the year you end up with a value of Stock A of $11,000.

Over the course of this same year, Stock B’s price per share doesn’t move up or down, but it does pay $1000 in dividends at the end of the year which you reinvest at that same $10 per share price.  At the end of the year, you end up with that same value of Stock B of $11,000.

Now here is where performance and cost basis drift apart:

When Stock A’s price grew, the value of the account grew to $11,000, but the cost basis remained the same at $10,000.  The added $1000 is considered unrealized appreciation which can be viewed as performance.

When Stock B paid its $1000 dividend and that dividend was reinvested, the cost basis of the account increased to $11,000.  

Summarizing the accounts at year’s end:

Does this seem familiar to you like when thinking about selling your house?  Haven’t we been told to keep up with the costs of the improvements we’ve made over the years so that our cost basis would be higher and we may pay less in taxes when selling?  Investing in your home is similar to reinvesting your dividends into your stocks when looking at capital gains and losses.

Investors sometimes confuse unrealized gain/loss for performance because they may not recognize the original cost basis was increased by reinvested distributions (dividends and capital gains).

Think about that non-qualified account again where you are reinvesting the dividends.  If the dividend was not added back into your cost basis, when the investment is sold you would have a higher gain and subsequently pay a larger capital gain tax.  The increasing cost basis is to your benefit, as you would not want to be subject to double taxation since dividends are taxable in the year they are paid.

So bottom line, cost basis should be used only to calculate capital gains and losses for tax filing purposes and not for measuring investment performance.

Now go back and look at your Schwab statement. Any stock may show a net unrealized loss (based on its cost basis) while the total value of that position over time has actually increased since the original purchase due to dividends being reinvested with more shares being owned.

https://investor.vanguard.com/taxes/cost-basis/basis-isnt-performance