Unrealized Gain/Loss is Not a Performance Metric

 In Investments, Taxes

Cost basis won’t tell you how much money you’ve made, but it will give you the information you need to file your taxes.

 

Some investors believe that you can measure a specific investment’s performance by looking at the unrealized gain/loss amount on the brokerage statement. The unrealized gain/loss amount is calculated based on the current fair market value less the cost basis of the investment (cost basis means the original purchase price plus reinvested distributions). Investors may confuse unrealized gain/loss for performance because they may not recognize the original cost basis was increased by reinvested distributions (dividends and capital gains).

In reality, when the distribution is reinvested, it gets added to your cost basis. The reason being is that you will pay tax on the dividend or capital gain that was reinvested (regardless of if you take it in cash or not). Therefore, 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 on the investment sold. This is to the investor’s benefit, as you would not want to be subject to double taxation!

Since the money was “earned” on the original investment, it is considered part of the investment’s performance. The number of shares you own increase and so does the cost basis for those shares. For this reason, cost basis should be used only to calculate capital gains and losses for tax filing purposes, not to measure investment performance.

Investor brokerage statements often show a “cost” for an investment in addition to its current market value. Lets’ take a look at a couple of examples:

Symbol Fund Name Average Price Per Share Total Cost Value on 12/31/16
VWINX Wellesley Income Fund Inv. $25.56 $28,638.94 $28,534.98

At first glance, the total cost of $28,638.94 exceeds the value of $28,534.98 on 12/31/2016, so you might think you “lost” money.  But what does “cost” mean in this case?  The cost shown on the account statement is the “tax cost” of the fund (also known as cost basis).  It is used for calculating capital gains for tax purposes when you eventually sell the fund.  The cost basis includes your purchases (what you put into the fund), as well as all the dividend and capital gain distributions that you reinvested into the fund.  You pay income tax on these each year, and since the distributions were used to buy more shares of the same investment, they add to the cost basis for the fund.  If you took the distributions in cash, you would still pay tax on them, but they would not add to cost basis for the fund.

The table below shows the initial purchase and all the various distributions through the end of 2016.

Date Transaction Description Share Price Shares Total Amount
5/12/2014 Initial Purchase 25.61 979.312 $25,080.17
6/20/2014 Dividend Received 25.91 6.841 $177.26
9/19/2014 Dividend Received 25.83 7.025 $181.45
12/17/2014 Dividend Received 25.34 8.623 $218.50
12/17/2014 Long-term Capital Gain 25.34 16.814 $426.07
12/17/2014 Short-term Capital Gain 25.34 0.901 $22.84
3/26/2015 Dividend Received 25.58 6.895 $176.38
6/19/2015 Dividend Received 25.43 7.265 $184.75
9/18/2015 Dividend Received 24.71 7.864 $194.33
12/16/2015 Dividend Received 24.59 9.403 $231.22
12/16/2015 Long-term Capital Gain 24.59 25.159 $618.67
12/16/2015 Short-term Capital Gain 24.59 0.635 $15.62
3/16/2016 Dividend Received 24.96 6.988 $174.43
6/16/2016 Dividend Received 25.7 7.886 $202.66
9/16/2016 Dividend Received 25.9 7.376 $191.03
12/23/2016 Dividend Received 25.46 9.755 $248.37
12/23/2016 Long-term Capital Gain 25.46 11.189 $284.86
12/23/2016 Short-term Capital Gain 25.46 0.406 $10.33
      Total: $28,638.94

The total in this table is the same as the Total Cost shown in the summary statement excerpt above. It’s what you would report to the IRS as the cost basis of the fund if you decided to sell it.

But what did you actually earn on the investment?  The only money you contributed is the initial purchase of $25,080.17 on May 12, 2014.  All reinvested dividend and capital gain distributions afterward were part of the investment earnings.  As shown in the chart below (from the Vanguard website for the account), the total investment returns through December 31, 2016 were $3,454.81.  Adding these two together gives December 31, 2016 account value of $28,534.98 from the first table.

So, the total return from May 12, 2014 through December 31, 2016 was $3,454.81.  This is 13.78 percent over a little more than 2 ½ years ($28,534.98/$25,080.17 -1) x 100.  This corresponds to an average annual rate of return of about 5 percent during the period from May 2014 through December 2016.

Here is another hypothetical example to consider:

Let’s say you invest $10,000 in Mutual Fund A and Mutual Fund B on the same day. The $10,000 investment is the original cost basis for each fund.

Original Cost Basis
  Mutual Fund A Mutual Fund B
Initial Investment: $10,000 $10,000
Price paid per share: $10 $10
Number of shares: 1,000 1,000
Original Cost Basis: $10,000 $10,000

During the first year, the value of Mutual Fund A goes up $1,000 because of market gains, but the fund pays no dividends. So, Mutual Fund A ends the year with a balance of $11,000.

Mutual Fund B, on the other hand, experiences no market gains but earns $1,000 in dividends, which are reinvested. The year-end account value, however, is the same $11,000.

Account Activity
  Mutual Fund A Mutual Fund B
Initial Investment: $10,000 $10,000
Increase from Market Appreciation: $1,000 $0
Dividends paid & reinvested: $0 $1,000
Price per share for reinvested dividends: $10
Number of shares purchased with reinvested dividends: 100
Year-end account value: $11,000 $11,000

Here’s where cost basis and personal performance start to differ.

When Mutual Fund A’s price increased, the value of the account increased to $11,000, but the cost basis remained the same at $10,000. The additional $1,000 is considered unrealized appreciation, which can be interpreted as performance.

When Mutual Fund B’s dividends were reinvested, the cost basis increased to $11,000 because the dividends were used to buy more shares and treated like any other investment made in the fund.

Year-End Cost Basis
  Mutual Fund A Mutual Fund B
Year-end account value: $11,000 $11,000
Number of shares: 1,000 1,100
Price per share: $11 $10
Capital gain: $1,000 $0
Year-end cost basis: $10,000 $11,000

So, although both funds did provide a 10% return, the unrealized gain/loss calculation would show that Mutual Fund B having not “made” any money. This is why unrealized gain/loss is not considered a performance metric.

 

Sources:

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

CB Bond – https://cbbondfinancialplanning.com/cost-basis-is-different-from-return

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