Investment cost, or cost basis, refers to the amount of money you initially paid to acquire an investment, such as stocks or mutual funds. This is not the investment's current market value but the original price you paid for it.
It is usually divided into several components, such as purchase price, brokerage fees, commissions, taxes, and other expenses. This initial investment cost serves as the basis for calculating capital gains or losses when the asset is eventually sold.
Let’s understand the cost of investment meaning in detail, learn how to calculate it, and study some common adjustments.
What is the cost of investment?
The cost of investment, often referred to as the cost basis, is the original value of an investment at the time of purchase. It represents the total amount of money paid to acquire the investment. This includes not only the purchase price of the asset but also any additional costs incurred during the purchase, such as:
- Brokerage fees
- Commissions, and
- Taxes.
Often, the cost of investment is used as a basis for calculating capital gains or losses when the investment is sold. That’s because when you sell the investment, you compare the selling price with the cost of the investment to determine your profit or loss. For example:
- Say you bought 25 shares of XYZ Ltd. for Rs. 1,000 apiece
- Later, you sold them for Rs. 1,500 per share
- In this case, your capital gain would be Rs. 12,500 [25 shares x (Rs. 1,500 - Rs. 1,000)]
Furthermore, it is essential to note that the cost of investment remains constant. It does not fluctuate as the market value of the investment. This consistency helps investors track the performance of their investments and accurately report gains or losses for tax purposes.
Components of investment cost
It is worth mentioning that the cost of investment is made up of various components, which collectively determine the initial amount spent on acquiring an investment. The primary components include the:
- Purchase price
- Transaction fees
- Taxes, and
- Other associated costs
Let’s study each of these components in detail:
1. Purchase price
The purchase price is the amount paid to acquire the investment. For example, if you are buying shares of a company, the purchase price is the cost per share multiplied by the number of shares you buy.
Usually, this is the most significant component of the investment cost. It directly reflects the market value of the investment at the time of purchase.
2. Transaction fees
Transaction fees include all the charges levied by brokers or financial institutions for facilitating the purchase of an investment. Some common examples of such charges are:
- Brokerage fees
- Brokers charge a fee for facilitating the buying and selling of stocks.
- Mostly, this fee is charged following three common brokerage models:
- Percentage of Trading Volume
- Flat per Trade Brokerage
- Unlimited Trading PlanTransaction charges
- Exchanges like the NSE and BSE charge a fee for using their platforms:
- For example,
- NSE charges 0.00325% of the total turnover for equity and delivery trading.
- Conversely, BSE charges 0.003% of the total turnover for the same.
- Depository Participant (DP) charges
- Be aware that depositories (NSDL and CDSL) charge fees for holding securities in electronic form.
- These charges are often passed on to investors by depository participants (DPs), such as brokerage firms.
- SEBI turnover charges
- The Securities and Exchange Board of India (SEBI) charges a fee on both buy and sell sides.
- The standard rate of this charge is Rs. 10 per crore of turnover.
3. Taxes
In India, there are several taxes applicable while buying assets. Commonly, these include:
- Securities Transaction Tax (STT)
- For the unaware, STT is a tax levied on transactions on the stock exchanges.
- For example, while trading in equities, STT is charged as follows:
- Equity Delivery: 0.1% on both buy and sell sides.
- Equity Intraday: 0.025% on the sell side.
- Equity Futures: 0.01% on the sell side.
- Equity Options: 0.05% on the sell side (on premium)
- Goods and Services Tax (GST)
- GST is levied at 18% on the total brokerage and transaction charges
Additionally, long-term and short-term capital gains taxes will apply when the investment is sold. For equities:
- Short-term capital gains (STCG) occur when shares are sold within 12 months. The applicable STCG tax rate is 15%.
- On the other hand, long-term capital gains (LTCG) occur when shares are held for more than 12 months. They are taxed at 10% for annual gains above Rs. 1 lakh without indexation.
For other assets, STCG is taxed as per income tax slabs, and LTCG at 20% with indexation benefits.
4. Other costs
Other costs include any additional expenses incurred during the purchase process. These usually involve stamp duty, a tax on the transfer of securities. This duty is charged by the state and applies only to the buy side.
For example, when you trade in the equity segment, you are required to pay the following stamp duty:
- Equity Delivery: 0.015% of the buy side
- Equity Intraday: 0.003% of the buy side
Similarly, when investing in real estate, you are required to pay registration fees and legal fees, which would be considered part of the other costs.
How to Calculate investment cost?
To calculate the cost of investment, you need to determine the weighted average cost (WAC) of the investment units. This reflects the average cost per unit of the investment over time. Let’s understand the process in some simple steps:
Step I: Recording investments
- Determine the amount invested and the price per unit at the time of purchase.
- For additional investments, repeat the process.
Step II: Calculate Weighted Average Cost (WAC)
- Calculate the WAC by dividing the total investment amount by the total units acquired.
- Apply the following cost of investment formula:
Weighted Average Cost = (Total inflows into fund)/(Total no. of units of fund bought) x Existing number of units of fund
Step III: Make adjustments for withdrawals
- Adjust the WAC for any units sold by reducing the total cost and units accordingly.
Always remember that the WAC changes with each transaction. This method helps you track the true cost of investments, which makes it easier to calculate capital gains or losses when the units are sold.
Related articles to read
- What is SIP investment
- How to invest mutual funds
- What is an investment product
- What are investment funds
- What is a lumpsum investment
Importance of knowing your investment cost
Accurately knowing your investment cost is fundamental for tax reporting. It enables you to accurately calculate capital gains taxes and assess the success of your investment strategies. Let’s understand in detail:
1. Tax reporting
The cost of investment helps calculate capital gains. That’s because it requires the cost basis of your investments. Both long-term and short-term capital gains taxes are computed based on the difference between the:
- Selling price
and - Cost of investment
Hence, you must maintain precise records of investment costs to ensure that you report your gains and losses correctly. This minimises the risk of tax discrepancies and potential penalties.
2. Performance evaluation
To effectively evaluate the performance of your investments, you need to know the original cost. This allows you to measure the return on investment (ROI) by comparing the current value of your investments to their cost basis.
For example, if your portfolio has appreciated, you can use the cost of investment to:
- Calculate the percentage gain
and - Assess whether your investment strategy is successful.
Based on this information, you can further make adjustments to your portfolio and ensure that your investments align with your financial goals.
3. Decision making
It must be noted that accurate knowledge of your investment costs assists in making informed decisions. When considering selling an investment, knowing the cost basis helps determine whether the sale will result in a gain or loss.
Additionally, this information is also useful when deciding to:
- Reinvest dividends
or - Make additional purchases
Thus, by understanding the cost basis, you can strategically plan your transactions and optimise tax benefits to maximise your overall portfolio returns.
Adjustments to investment cost
There are several instances when you need to make adjustments to your cost of investment. Making these adjustments is necessary as they help in accurate financial tracking and tax reporting. Let’s have a look at some common adjustments:
Stock splits
When a company issues a stock split, it increases the total number of shares outstanding. This split proportionately reduces the price per share. Also, it causes the overall cost of investment to remain the same but adjusts the cost per share. For example,
- Say you originally bought 100 shares at Rs. 200 each
- The company announced a 2-for-1 split
- Now, after the split, you will have 200 shares at Rs. 100 each.
- Your total cost still remains the same i.e., Rs. 20,000, but your holding cost per unit is reduced from Rs. 200 per share to Rs. 100 per share.
Dividend reinvestments
When you invest in stocks that pay dividends, you usually have two options: either receive dividends as cash directly into your account or use them to automatically buy more shares of the same stock. Now, when you reinvest dividends to buy more shares, the cost of those additional shares is added to your initial investment cost. This increases your overall cost basis (total cost of your investment).
For example:
- Say you initially invest Rs. 1,000 in a stock.
- Over time, you receive Rs. 100 in dividends.
- Instead of taking the dividends as cash, you reinvest them to buy more shares.
- Let's say you buy Rs. 100 worth of additional shares with these dividends.
- Now, your total investment (cost basis) is Rs. 1,100 (Rs. 1,000 initial investment + Rs. 100 reinvested dividends).
When you sell these shares in the future, your capital gains or losses will be based on this adjusted cost basis of Rs. 1,100, not just the original Rs. 1,000.
Additional purchases
When you buy more shares of an existing investment, the total investment cost increases. This involves recalculating the average cost per share, which now reflects the combined amount paid for all shares owned.
Common mistakes and how to avoid them
- Ignoring transaction fees:
- Always include brokerage fees, commissions, and taxes when calculating the cost of investment.
- Keep detailed records to ensure accuracy.
- Forgetting dividend reinvestments
- Add reinvested dividends to your cost basis.
- Track these transactions meticulously.
- Not adjusting for stock splits
- Adjust the cost per share when a stock split occurs.
- Update your records to reflect the new number of shares and adjusted price.
- Overlooking additional purchases
- Combine the cost of additional shares with existing ones to calculate the new average cost per share.
- Miscalculating capital gains
- Use accurate cost basis to avoid errors in capital gains tax calculations.
- Review tax rules periodically for updates.
Conclusion
The cost of investment represents the total amount you initially paid to buy an asset. Commonly, it is the sum of purchase price, fees, duties, and taxes. This cost forms the basis for calculating gains or losses when you decide to sell your investment. Hence, it is always advisable to maintain accurate records for tax reporting and evaluating investment performance.
Furthermore, adjustments like stock splits, dividend reinvestment, or additional purchases require updating the cost basis per share. By accurately knowing your cost of investment, you can make informed decisions, optimise tax benefits, and minimise errors while making and reporting tax calculations.
