Investor Returns vs. Unrealized Gain/(Loss) Cost Basis Reporting
Written by Ethan S. Braid, CFA on 11.01.2016
The author, a fee-only registered investment adviser with more than seventeen years of experience, manages $80 million dollars of client assets for high net worth investors. The goal of the article is to help consumers learn the difference between investor return on investment and unrealized gain/(loss) cost basis reporting for an investment. Many large custodians ($500 billion or more in client assets) do not show investor return on investme on nt on their clients’ statements. Instead these custodians simply demonstrate the unrealized gain/(loss) relative to cost basis on the securities held in an investor’s account. Since this gain/(loss) is shown from an unrealized taxable gain/(loss) perspective, investors frequently believe they are losing money on an investment when in fact they are making money.
Why am I losing money?
In my role as an investment adviser, I have the distinct privilege of providing advice to clients who have achieved great success in their respective careers and businesses. Many have degrees from the top universities of the world. They are highly specialized surgeons, attorneys, entrepreneurs, educators, engineers and CPAs. They are smart, disciplined and worked exceptionally hard to create their wealth. Yet so many times over the years, clients have asked me why they are losing money on securities they hold when in fact they are making money. How could this be I wondered, my clients are smart, how can they not realize they are making money and instead think they are losing money? The factor causing the confusion is how custodians demonstrate gain/(loss) on client statements. Many custodians only show unrealized gain/(loss) as it relates to cost basis and nothing more. ROI is ignored. To help mitigate the confusion, I have produced this educational article.
Let’s start with return on investment.
Return on investment (ROI), a very simple and important performance metric, is often neglected on many custodians’ statements.
ROI = (Investment Ending Value – $ invested)/$ invested
It is important to note that for securities that pay dividends, all dividends paid, whether in cash or in additional shares of the security, need to be included in the investment ending value. If the dividends are in the form of additional shares, then the ending value of those shares will be used for the ROI calculation.
An example for the sale of a stock that was held for ten years:
- Purchase of XYZ for $50,000 with no further additions, $ invested = $50,000
- Cumulative dividends reinvested in XYZ over 10 years in the amount of $20,000
- At the end of 10 years XYZ is liquidated for a total investment ending value of $65,000
ROI = ($65,000 - $50,000)/$50,000 = 30%
Total Pre-Tax Profit = $65,000 - $50,000 = $15,000
How would unrealized gain/(loss) cost basis reporting be different?
Sticking with the same example, we first need to highlight how unrealized gain/(loss) is reported. Custodians report unrealized gain/(loss) on their statements as follows:
Unrealized gain/(loss) = Current Value – Cost Basis.
Current value is what you could sell the investment for. Cost basis is what you invested + any dividends or capital gains that have been re-invested. In this case, the cost basis would be $50,000 + $20,000 = $70,000. Therefore, on many custodian statements, the 30% ROI for the above investment would instead appear to be an unrealized (loss) calculated as:
Unrealized gain/(loss) = $65,000 - $70,000 = ($5,000) (loss)
This investor has made a cumulative pre-tax return on his investment of $15,000 or 30%. His custodian however, is showing that he is losing money to the tune of ($5,000). How confusing. Frustrated? Blame the IRS. The custodian is focused on showing what would happen, in terms of taxable activity, if the investor sold the investment today. Because past dividends have already been received and taxed, those dividends adjusted the cost basis of the investment upward by the amount of the dividends received. Since the investment’s value is currently less than the total of the $ invested plus the past dividends received (and taxed), it could be sold for a loss. This loss however is a tax loss. The tax loss of ($5,000) does not change the fact that the investor had a pre-tax return of $15,000 overall.
Don’t forget the dividends!
In my experience, when addressing this topic with clients and prospective clients, neglecting dividends is often at the root of the confusion. Additionally, many investors do not know the difference between ROI and unrealized gain/(loss) vs cost basis. Most investors tend to look at the unrealized gain/(loss) reported on their custodian’s statement and forget that the cumulative dividends need to be either added to the current value or subtracted from the cost basis, in order to calculate ROI. Cumulative dividends would be added to ending value in the ROI calculation if they were never reinvested. Cumulative dividends would be subtracted from cost basis in the ROI calculation if they were re-invested.
Ex. for adjustment of Current Value in the ROI calculation, dividends were not re-invested:
Adjusted Current Value = Current Value + Cumulative Dividends Received in Cash
ROI = Adjusted Current Value/$ invested
Ex. for adjustment of Cost Basis in the ROI calculation, dividends were re-invested:
Adjusted Cost Basis = Cost Basis – Historical Value of Cumulative Dividends Re-invested
ROI = Current Value/Adjusted Cost Basis
Ethan S. Braid, CFA
HighPass Asset Management
800 – 672 - 7916
About the author of this article.
Ethan S. Braid, CFA is the founder of HighPass Asset Management – an independent, fee-only, registered investment advisory firm with a fiduciary duty to the clients it serves. Mr. Braid has been passionate about managing client investment portfolios and providing customized financial planning advice since he started working in the investment industry over 17 years ago. Mr. Braid earned a BS in finance from Robert Morris University, an MBA from Cleveland State University and he is also a CFA charterholder. The CFA program is a graduate level, globally recognized, multi-year program with a focus on investment knowledge. Candidates for the program commit an average of 900+ hours of cumulative study time to complete all three levels.
Mr. Braid is devoted to being an expert in the field of wealth management for high net worth individuals and families and for many years, has read one book per month on subject areas such as: estate planning, retirement planning, investment analysis, mergers & acquisitions, business history and behavioural finance. Mr. Braid has a passion for business history with a focus on the late 19th & early 20th centuries. To date, Mr. Braid has read 72 books on the subject areas above.
When Mr. Braid is not helping clients, he enjoys: cooking, wine, exercise, his yellow Labrador retriever, fly fishing, hiking, travel, playing guitar, snowboarding and duck hunting. Mr. Braid is a committee member of the Denver Chapter of Ducks Unlimited.
This article is provided by HighPass Asset Management for informational purposes only. No portion of this commentary is to be construed as a solicitation to buy or sell a security or the provision of personalized investment or legal advice.