Be Above Average, by Averaging Above
“I don’t want to miss out on these low prices, but I hate to average up my cost basis!”
We’ve all heard the phrase. Heck! Many of us have said the phrase. Despite our best intentions, however, is this really the right mindset to have? Perhaps we need to see it on paper before we can make a decision.
I am going to use a hypothetical situation to demonstrate this scenario. Before I begin, please note that I could have changed out ANY number of variables, but the end result would still be the same. So although this example may not replicate exactly your own personal journey, the outcome can be applied directly to you and your specific situation.
Let’s assume we have two investors:
“Just John” and “Savvy Sarah”.
We’ll just call them John and Sarah for short.
John and Sarah both discovered Microvision, Inc. (NAS: MVIS) on the same day: July 24, 2020.
Interestingly enough, they both decided to invest $2,500, which was filled at the daily average price of $2.01. Because their brokers allow them to purchase fractional shares, they both were able to purchase 1,243.78 shares of MVIS. How happy are they!
Even though John and Sarah have never met before, they both have the same plan: Every two weeks, both John and Sarah will invest another $150 into Microvision.
There is one slight difference between their two plans, however. John gets sick to his stomach whenever he thinks about the idea of “averaging up” on his stock purchases. If the stock price on his planned purchase date is higher than his cost basis, then he will not purchase. He will spend that $150 in some other way. Sarah, on the other hand, is content to continue purchasing, regardless of the stock price.
Let’s take a quick break and discuss what “averaging up” means. When you purchase stock, the average price you pay for each individual stock is called your “cost basis”. The cost basis is important because it is used by the IRS to determine your taxable income from investments, if you have any. As you purchase stock at differing price levels, the average cost that you pay over the entire life of your investment will change. If you continue to purchase stock at a lower price point, then you will “average down” your cost basis. If you continue to purchase stock at a higher price point, then you will “average up” your cost basis. Now that we understand what cost basis is and how differing prices can affect it, let’s get back to our example.
Two weeks have passed since John and Sarah both initially invested into MVIS. It is time to purchase $150 more of the stock. Fortunately for John, the price has dropped from $2.01 to $1.77. He makes another $150 purchase and collects 84.75 shares of MVIS. Sarah makes the same exact purchase. They both now have 1,328.53 shares of MVIS valued at an average price of $1.99 per share.
As the weeks go on, the price of MVIS fluctuates up and down. John and Sarah follow their investment plan to the “T”. To speed up the timeline, I will place the purchasing history in a graph below:
According to this article from Reuters, as of the end of 2019, the average amount of time that an investor held a stock was for 8.5 months. John and Sarah have already broken that trend by 3 weeks – that is dedication. However, all great things must come to an end. Both John and Sarah are strapped for cash and decide to sell their investments on April 30, 2021. The average daily trading price was $14.91. They sell all of their shares at this price.
Now is the time to learn if John was smart for never averaging up his cost basis.
As of April 30, 2020, here is what both of their accounts look like:
Cost Basis/Share:$. 1.90 $ 2.51
Total Invested $: 3,400.00 $ 5,500.00
Total Shares: 1,793.26 2,194.52
Total Value: $26,728.59 $32,709.29
We can see that Sarah’s plan, even though it required her to “average up”, yielded her more shares and more money in the end. Additionally, since the data shows that investors do not hold stocks longer than 8.5 months on average, most investors are paying a short-term capital gain tax on the money that was earned. As of this writing (May 2021), a short-term capital gain is taxed using the standard tax brackets that the IRS uses to determine a person’s normal income. This can range anywhere from 10% to 37%. According to this article by “The Balance”, the average American will fall into the 24% tax bracket. Let’s assume that both John and Sarah are average Americans. They, too, will pay 24% of their capital gains into taxes.
It is true that Sarah will pay more taxes in terms of dollars, because she earned more money. But, let’s be clear: Both John and Sarah will pay the same percentage of taxes in relation to the gain that they received. However, because Sarah’s cost basis is higher than John’s, the percentage of taxes paid in relation to her total account balance is lower. Sarah did not save any money on taxes by averaging up, but she does get to utilize a higher percentage of the current account balance when she sells MVIS and withdraws the money. So averaging up does allow Sarah to pocket a larger percentage of her $32,709.29 account balance.
Rendesen is not a financial advisor. The use of any tickers or companies within this article are not a recommendation to buy or sale. The data used for the MVIS stock price is historical data that was published to finance.yahoo.com. Past performance is no indication of future performance. The historical data was simply used for explanatory purposes. Remember that trading does involve risk, including the loss of money. As you trade in the stock market, you do so at your own discretion. As of this writing, Rendesen holds a long position in Microvision, Inc (NAS: MVIS).
This article was written by Discord member “Rendesen”
Thanks for reading. Take care and God Bless!