Understanding Average Cost Basis
Your average cost basis (also called average cost per share) is the weighted average price you paid for all shares of a stock, including any fees. It's essential for understanding your true investment performance and calculating capital gains for taxes.
Average Cost = Total Amount Invested ÷ Total Shares Owned
Weighted average cost per share calculation
Why Average Cost Matters
For Tax Purposes
When you sell shares, your capital gain or loss is calculated as:
Capital Gain = Selling Price - Cost Basis
Determines your taxable profit
Example
For Investment Decisions
- Determines your break-even selling price
- Helps evaluate whether to buy more at current prices
- Provides true return percentage (not just price change)
- Useful for tax-loss harvesting decisions
Dollar-Cost Averaging
Dollar-cost averaging (DCA) is an investment strategy where you invest a fixed amount regularly, regardless of the share price. This naturally results in buying more shares when prices are low and fewer when prices are high.
| Month | Investment | Price/Share | Shares Bought | Total Shares |
|---|---|---|---|---|
| Jan | $500 | $50 | 10.0 | 10.0 |
| Feb | $500 | $45 | 11.1 | 21.1 |
| Mar | $500 | $55 | 9.1 | 30.2 |
| Apr | $500 | $40 | 12.5 | 42.7 |
| May | $500 | $50 | 10.0 | 52.7 |
Example: $500/month investment
Total invested: $2,500. Total shares: 52.7. Average cost: $47.44— better than the average price of $48.
DCA Advantage
Averaging Down vs Averaging Up
Averaging Down
Buying more shares after the price drops to lower your average cost.
| Purchase | Shares | Price | Total Cost | New Average |
|---|---|---|---|---|
| Initial | 100 | $50 | $5,000 | $50.00 |
| After drop | 100 | $35 | $3,500 | $42.50 |
| Total | 200 | — | $8,500 | $42.50 |
Danger of Averaging Down
Averaging Up
Buying more shares as the price rises, usually because of strong performance or growing conviction.
- Shows confidence in an improving business
- Can be part of a 'winner's portfolio' strategy
- Raises your average cost but may still be profitable
- Common among professional traders building positions
IRS Cost Basis Methods
The IRS allows different methods for calculating cost basis when selling:
| Method | Description | Best For |
|---|---|---|
| Average Cost | Sum of costs ÷ shares (mutual funds) | Simplicity, mutual funds |
| FIFO | First shares bought, first sold | Default for stocks |
| LIFO | Last shares bought, first sold | Minimizing gains |
| Specific ID | Choose which shares to sell | Maximum tax control |
Mutual Funds vs Stocks
What's Included in Cost Basis
- Purchase price of shares
- Trading commissions and fees
- Reinvested dividends (DRIP shares)
- Any return of capital distributions
- Corporate action adjustments (splits, mergers)
Stock Splits
When a stock splits (e.g., 2-for-1), your share count doubles but your average cost halves. Your total cost basis remains unchanged.
Split Example
Dividend Reinvestment (DRIP)
When dividends are reinvested to buy more shares, each purchase has its own cost basis. This can get complex over years of reinvestment.
Keep Records
Frequently Asked Questions
Q: Does selling affect my average cost?
A: Selling removes shares from your holdings but doesn't change the average cost of your remaining shares. However, your total cost basis decreases proportionally.
Q: How do I find my cost basis?
A: Your brokerage tracks this for you — check your account statements or tax documents. For older holdings or transferred shares, you may need original records.
Q: What if I don't know my cost basis?
A: For older securities without records, the IRS may treat your cost basis as $0, meaning 100% of proceeds are taxable gains. Try to reconstruct records from old statements.
Q: Does the wash sale rule affect cost basis?
A: Yes. If you sell at a loss and repurchase within 30 days, the loss is disallowed and added to the cost basis of the new shares.
Q: How do mergers and acquisitions affect cost basis?
A: It depends on the deal structure. Sometimes your cost basis transfers to the new shares; sometimes there's a taxable event. Your broker should provide guidance.
Q: Should I include fees in my cost basis?
A: Yes. Trading commissions and fees increase your cost basis, which reduces your taxable gain when you eventually sell.
Best Practices
- Keep records of all purchases, including dates and prices
- Track reinvested dividends as new cost basis
- Review your broker's annual tax summary (Form 1099-B)
- Understand which cost basis method your broker uses
- Consider specific identification for tax-efficient selling
- Update records for stock splits and corporate actions
This information is for educational purposes and should not be considered tax advice. Cost basis rules are complex and IRS regulations may change. Consult with a tax professional for personalized guidance on your specific situation.