cost basis

Confusing Cost Basis with Fund Performance

cost basis

In our last post, we introduced two investment terms that are a little more technical than we normally prefer, but worth knowing when you want to accurately measure your portfolio’s performance:  Time-Weighted Rate of Return (TWR) and Internal Rate of Return (IRR).

Since calculating rates of return and portfolio performance requires complex formulas and computer software that may not be readily available, we often see investors turning to an investment’s cost basis to answer their performance questions. This is not a strategy we recommend, as it is the wrong tool for the job.

What is Cost Basis?

Put simply, it is what you paid for your shares.

Cost basis is used to determine your taxable capital gains or losses, which is why keeping accurate records is extremely important.  Remember, the IRS requires you to report realized capital gains and losses on Schedule D of your tax return.

Calculating Cost Basis

It begins with how much you spent on the initial investment, but there’s often more to it than that. Many investments yield dividends, interest or other distributions along the way. You typically can choose to reinvest distributions in additional shares of the same investment, or you can take them in cash, and spend or  invest them elsewhere.

From a tax-planning perspective – For tax purposes, reinvested distributions used to purchase more shares increase your cost basis and impact your capital gain (or loss) when you go to sell the security. Distributions taken as cash do not become part of your cost basis.

From a performance perspective – Whether you reinvest distributions or take them in cash, they should be considered part of your return. After all, when a stock pays a dividend or a bond generates interest, it represents earned money that you didn’t have before.

If you’re following the bouncing ball, this means that, if you try to compare a holding’s cost basis to its current value to see how well you’ve done, your answer may well be inaccurate. Whether you’ve taken your distributions as reinvestments or in cash, they’re “disappearing” from the equation, so your guesstimated returns will appear to be lower than they actually were.

Vanguard’s Mathematical Illustration of Cost Basis in Action

We encourage you to visit Vanguard’s Cost Basis Resource Center for more insight. In the opening section, “What is cost basis?” you’ll find a simple math illustration by clicking on the link: “Learn more about why cost basis is not performance.” There’s also a handy video on the same page.

The Bottom Line

In the end, look at your cost basis information to help you figure out the tax consequences of selling an investment.  If your intent is to better understand performance, focus on IRR or TWR.

louie ckSage Serendipity: Two of my favorite comedians – Louis CK and Charles Grodin – illustrate how there are always new ways to view ingrained assumptions in “Misery Is Wasted on the Miserable.”

Sheri Iannetta Cupo, CFP®, Founding Partner (Retired) & Director
[email protected]

SAGEbroadview Wealth Management is a Fee Only firm offering ongoing financial planning and portfolio management, with tax planning woven carefully throughout our services. We work virtually across the country, with offices in Farmington, CT, Morristown, NJ, and Burlington, MA.