Average Cost Method

Over a period of fluctuating prices, dollar cost averaging produces an average cost per share that is:

1. A.Lower than the average of the purchase pricesCorrect - the math favors the investor when prices vary.
2. B.Higher than the average priceThis is the reverse of what the method produces. Investing a fixed dollar amount buys more shares when prices are low, and those cheaper shares carry more weight in the total, pulling average cost below the average price.
3. C.Always equal to NAVEach periodic purchase is made at whatever price prevails that day, and in a loaded fund that price is the offering price rather than NAV. The result is a blend of many different prices, not any single day's net asset value.
4. D.Exactly the average priceThis would be exactly right under a different plan: buying the same number of shares each period does produce an average cost equal to the average price. Fixed dollar investing changes the weighting, since more shares are acquired at low prices, so the average cost comes out below the average price.

Why: Because fixed dollars buy more shares at low prices and fewer at high prices, the average cost is lower than the simple average of the prices paid.

Ines Delacroix bought 400 shares of Talbridge through Wexler Securities in 2014. She separately holds 300 shares of the same stock that she deposited into the account from an old paper certificate, with no purchase records. She now sells both positions. How does cost basis reporting work?

1. A.Neither sale is reported to the IRS, because basis reporting applies only to mutual fund shares.Wrong. All sales are reported on Form 1099-B, and basis reporting covers equities as well as fund shares, debt and options.
2. B.Wexler must report basis for both lots, since both are held in the same account at the same broker.Wrong. Custody does not create covered status. Shares transferred in without acquisition data remain noncovered.
3. C.Wexler reports gross proceeds only for both lots, because brokers never report cost basis to the IRS.Wrong. Brokers have been required to report adjusted basis for covered securities for years; that is the whole point of the covered/noncovered distinction.
4. D.The 2014 purchase is a covered security, so Wexler reports her adjusted basis to the IRS; the certificate shares are noncovered, so Wexler reports proceeds only and Ines must substantiate her own basis.Correct. Covered status depends on when and how the security was acquired, and the two lots fall on opposite sides of the line.

Why: Brokers must report the customer's ADJUSTED COST BASIS to the IRS, not just gross proceeds, but only for COVERED securities - broadly, equities acquired through the broker on or after January 1, 2011 (with later effective dates for fund shares and for debt and options). Ines's 2014 purchase is covered, so Wexler reports both proceeds and her basis on Form 1099-B. The certificate shares came in without acquisition information and are NONCOVERED: Wexler reports the sale proceeds but leaves the basis blank, and Ines bears the burden of substantiating what she paid.

Estelle invests 600 dollars on the first business day of each month in Danforth Index Fund for four months. The purchase prices are 20 dollars, 25 dollars, 30 dollars and 24 dollars per share. Rounded to the nearest cent, how does her average cost per share compare with the average of the four purchase prices?

1. A.Average cost is 24.24 dollars, about 51 cents below the 24.75 dollar average priceCorrect. 600/20 + 600/25 + 600/30 + 600/24 = 30 + 24 + 20 + 25 = 99 shares; 2,400 / 99 = 24.24 dollars, versus a 24.75 dollar average price.
2. B.The two are identical at 24.75 dollars, because equal dollar amounts were invested each monthEqual dollar amounts are exactly what makes them differ. Equal share purchases each month would make them identical.
3. C.Average cost is 24.75 dollars and average price is 24.24 dollars, so average cost is the higher figureThe two values are reversed. In a fluctuating market, fixed-dollar investing always produces an average cost at or below the average price.
4. D.Average cost is 25.50 dollars, because the two highest prices dominate the total investedThe opposite is true - the high-price months buy the fewest shares, so they carry the least weight in the average cost.

Why: Fixed-dollar investing buys more shares when prices are low and fewer when they are high. Shares bought are 30, 24, 20 and 25, for 99 shares total on 2,400 dollars invested, so average cost is 24.24 dollars per share. The simple average of the four prices is (20 + 25 + 30 + 24) / 4 = 24.75 dollars. Average cost is lower - that is the arithmetic behind dollar cost averaging. The clue is the fixed 600 dollars per month rather than a fixed number of shares. Review: dollar cost averaging. Trap: expecting the two figures to be equal or expecting a guarantee of profit.

In a taxable account, Ysolde bought 400 shares of Merriwether Fund at $25.00 and, two years later, 600 shares at $30.00. There have been no distributions. She now redeems 500 shares at a net asset value of $34.00 and has elected the average cost method for this fund. What gain does she report?

1. A.$17,000This treats the entire redemption as gain and assigns no basis at all. Basis is recovered tax-free on every sale of shares bought with after-tax money.
2. B.$3,000Correct. The pooled average cost is $28.00 per share, so $17,000 of proceeds against $14,000 of basis leaves a $3,000 gain.
3. C.$2,000This identifies the 500 highest-cost shares, each with a $4 gain. Specific identification requires timely instructions to the fund and was not the method elected here.
4. D.$4,000This is the first-in, first-out result: 400 shares at a $9 gain plus 100 shares at a $4 gain. FIFO is the default when no method is elected, but she elected average cost.

Why: Average cost pools every share: total cost is (400 x $25.00) + (600 x $30.00) = $10,000 + $18,000 = $28,000 across 1,000 shares, or $28.00 per share. Proceeds are 500 x $34.00 = $17,000, and the basis assigned is 500 x $28.00 = $14,000. The reported gain is $3,000.