David R. Evanson
Privately Published, Spring, 2004
Determining performance is a bedrock principle of investing, but many investors often pay little attention to their cost basis, which an essential element in measuring performance. As a first step, let’s examine why cost basis is such an important concept.
Without an accurate basis, it is pretty difficult to determine your return. Knowing your return will allow you to make intelligent decisions on whether to hold or sell an asset. In addition, the basis will determine your gain or loss, which will affect your tax liability. The taxes you pay – or don’t pay – play an important role in the ultimate return you earn on an investment.
In essence, cost basis, or simply basis, is the total amount of money invested in a security, such as a stock, bond, or mutual fund. If you invested $1,000 each year over a five-year period in the T. Rowe Price Spectrum Growth fund and did not reinvest dividends or capital gains, the cost basis of your investment would be $5,000.
The IRS allows three methods for determining the cost basis—First In, First Out (FIFO), Average Cost, and Specific Identification. The Average Cost (or “Average Basis”) method, the most commonly used, requires you to determine the average cost per share—total dollars invested divided by the total number of shares held. In this discussion, we will be focusing on the average basis. Remember you will need to keep copies of your confirmations to accurately calculate your cost basis.
Using the above example, if you sell your investment in the Spectrum Growth Fund after it appreciates to $6,000, you will enjoy a $1,000 gain; if you sell it after it declines to $4,000 you will have a $1,000.. In the first scenario, taxes are owed. In the second, you have losses that you can use to offset other gains.
Now, let’s dig a little deeper because you may make periodic investments or reinvest your distributions.
Let’s examine periodic investments. If you were to buy $1,000 worth of the Spectrum Growth fund each year for three years at $10 per share in year one (100 shares), $12 per share in year two (83.3 shares) and $15 per share (66.7 shares) in year three, your total investment is $3,000. The total number of shares you own is 250 (100 + 83.3 + 66.7). Your average cost basis is $12 per share ($3,000 / 250).
Interestingly, the price you pay each time you purchase shares has no bearing on the basis. You still paid $1,000 each time. The cost basis per share is however a useful tool for understanding how an investment is doing since it represents the average cost per share.
Let’s take a look at how reinvested distributions influence basis. Using the above example, assume you receive a $100 distribution, which you immediately reinvest (a feature available to all T. Rowe Price investors) at the prevailing price of $15 per share. Your reinvestment nets you 6.7 shares of the fund. Your new basis in the Spectrum Growth fund is $3,100 ($3,000 initial investment + $100 reinvestment) and your cost basis per share is now $12.08 ($3,100 / 256.7).
Another important area is the cost basis of assets you receive as a gift. If you are lucky enough to get such a gift, you should immediately record the current value and the basis of the shares you receive. Be sure to ask the person giving you the gift.
Let’s say your grandmother gives you shares of the Spectrum Growth Fund. In general, her basis is now your basis. If she paid $3,000, that’s the figure you should use when calculating your gain or loss from selling. The situation gets a little more complex if, however, her basis is $3,000 and the day she “gifts” you, the shares are worth $2,000.
• If you sell the shares for less than $2,000, the Internal Revenue Service (IRS) says your basis is $2,000 and you have a loss equal to $2,000 minus whatever you sold the shares for.
• If you sell the shares for more than $3,000 the IRS says your basis is $3,000 and your gain is the proceeds from the sale, less $3,000.
• If you sell the shares for between $2,000 and $3,000 the IRS says you do not have a gain or a loss.
At T. Rowe Price, we’ve made considerable investments in technology so you can see the cost basis of your investments. We calculate your cost basis by using the average cost method factoring in all your purchases including reinvesting dividends and capital gains distributions. We include the cost basis information on Form 1099-B (mailed in January) for your convenience, but we do not report the cost basis to the IRS.
If you have signed up to transact orders on your T. Rowe Price mutual fund accounts on our Web site, you can find the average cost basis of your shares posted on the Mutual Fund Account Snapshot of each fund. (Average cost basis information is not provided for money market or tax-deferred retirement accounts.) If we do not have the cost basis for your mutual fund accounts, you can download a Cost Basis Information Form from the Forms section of our Web site. Fill it out and send it to us. We will then post the cost basis to your account.