 # Average Cost Basis

## Definition

Average Cost Basis is a method of calculating the value of an investment by taking the total amount of money spent over a certain period and dividing it by the total number of shares bought. It averages out the cost paid for each share, hence it’s called ‘Average Cost Basis’. This method is generally used to calculate the cost basis for mutual funds, making it easier to calculate gains or losses for tax purposes.

### Phonetic

The phonetic pronunciation of “Average Cost Basis” is: æ-və-rɪʤ kɑːst beɪ-sɪs.

## Key Takeaways

<ol><li>Average Cost Basis is frequently used as a method to calculate the cost of investments for taxation reasons. This method combines the purchase price of all shares of an investment and divides it by the total number of shares to determine the average cost per share.</li><li>One advantage of using the Average Cost Basis method is that it mitigates the effect of price volatility. As the cost is averaged out over the number of owned shares, the potential impact of market fluctuations is reduced. This makes it potentially simpler for investors to manage their tax obligations.</li><li>However, there may be potential disadvantages with the Average Cost Basis method, one of which is that it can produce higher taxable income. This is because it is harder to minimize capital gains, as it doesn’t account for the individual cost of each share, but rather the average cost of entire holdings.</li></ol>

## Importance

The Average Cost Basis is an important term in business and finance as it plays a crucial role in acknowledging the cost of an investment. It is a method used to calculate the value of an investment by dividing the total amount of money spent on buying securities by the total quantity of securities bought. This method becomes particularly significant when dealing with investments that are made at different points of time and at different prices, such as mutual funds. It helps in determining capital gains or losses for tax purposes when you sell your investment, hence impacting the level of tax liability. An accurate calculation of the average cost basis can help individuals and companies to manage their investments more effectively.

## Explanation

The Average Cost Basis is a method used by investors to determine the amount spent on an investment, for the purpose of understanding profits or losses and for tax reporting. It calculates the total cost incurred to purchase an asset and divides it by the total number of shares bought to find the average cost per share. This plays pivotal role in accurately figuring out capital gains or losses when a portion of or all of the investment is sold. This approach aids in simplifying record-keeping and minimizing the impact of high fluctuations in a specific purchase’s cost basis, especially when an investor buys a particular asset at different points in time and at diverse prices. Particularly for mutual fund investors, the average cost basis remains a commonly used method as investments are typically done periodically over time with prices varying at each acquisition. Moreover, it helps in the estimation of taxes owed on the sale of the assets, serving as a standardized protocol for the assessment of tax liability.

## Examples

1. Investing in Mutual Funds: An individual may choose to invest a set amount into a particular mutual fund each month. The price of shares in the mutual fund can fluctuate every month, meaning that some months the individual is able to purchase more shares and other months less. By using the average cost basis method, the cost of investment is averaged out over the number of shares purchased. This can simplify calculations for capital gains tax when the individual decides to sell. 2. Stock Market Investments: Suppose an investor purchases 100 shares of a company’s stock at \$50 each in January. Later in June, they decide to purchase another 50 shares of the same stock, but the price has increased to \$60 each. Using the average cost basis, the average cost of each share would be calculated by adding up the total cost of all shares (\$5000+\$3000=\$8000) and dividing by the total number of shares (100+50=150), giving an average cost of \$53.33 per share. 3. Real Estate Investment: A real estate investor may buy multiple properties in the same area at different times and prices. Each property would potentially have different operational costs (maintenance, taxes, etc.) and different rental incomes. By taking the average cost basis, the investor can get an average figure for the cost of owning and operating the properties. This can help in assessing profitability and making future investment decisions.

What is Average Cost Basis?
Average Cost Basis is a method of calculating the value of an investment by averaging the cost of all the shares you own. It is determined by dividing the total investment in a particular asset by the number of units or shares held.
How is Average Cost Basis calculated?
It is calculated by adding up the cost of all your shares then dividing that by the number of shares you own.
What is the purpose of using the Average Cost Basis method?
The main purpose of using the Average Cost Basis method is to simplify the process of calculating taxes on investment gains or losses.
When does Average Cost Basis become useful?
The Average Cost Basis method becomes especially useful when you own a large number of shares with varying purchase prices and want to sell some, but not all of them.
Can Average Cost Basis be used for all types of investments?
No, the Average Cost Basis method is typically used for mutual funds, while investments like individual stocks or exchange-traded funds (ETFs) usually use the First-In, First-Out (FIFO) or Last-In, First-Out (LIFO) methods.
What is the difference between Average Cost Basis and Adjusted Cost Basis?
Average Cost Basis considers the purchase price of all shares and averages them out. On the other hand, Adjusted Cost Basis considers factors such as dividends, stock splits, and additional purchases or sales to adjust the original cost basis of the investment.
Is it mandatory to use the Average Cost Basis method?
No, it’s not mandatory. It is one of several methods available to calculate the cost basis of investments. Investors can choose the method that best suits their tax planning needs.
Can I change my cost basis method after I sell my shares?
No, the IRS requires that investors choose a cost basis method before selling their shares. Once the sale has been made, you cannot change the method retroactively.
Can the Average Cost Basis method affect my taxes?
Yes, the method you choose to calculate the cost basis can influence your capital gains or losses, hence impacting your taxable income.