Properly Measuring Investment Profits

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Measuring the profits one makes off of one's investments can be a tricky business. The value of a dollar changes from year to year, often reducing the "value" of a profit, even if the number is rather high. A profit of $500 today doesn't mean nearly what it meant in the 1950s.

Suppose we buy an investment for $1,000, including buying expense, and sell it for a net of $1,500, after deducting selling expense. Customarily we say we have a profit, before tax, of $500; and if we pay a 15 percent Federal capital-gain tax of $75, our profit after this tax is $425. Within certain limits, these statements may be correct, but they can be quite deceptive for a long-term investor.

Here is the queer part. Before determining whether we have a profit or loss, and how much, we must adopt some standard way to measure the value of cost and sale. People generally take it for granted that the dollar is the proper standard for measuring, as in the example above. The federal government compels a taxpayer to use this standard in figuring the tax on a capital gain or loss. But presumably a man does not engage in long-range investing merely to collect dollars; what he is aiming for is future buying power. From this viewpoint, a sale of an investment is profitable to the extent that it gives him more buying power than he paid in when he bought.

Suppose we paid $1,000 for an investment in 1940 and sold it for $1,500 in 1957. During the intervening 17 years, according to the U.S. Government's index of consumer prices, the cost of living just about doubled. To make a sale that would give buying power equal to $1,000 in 1940, the price in 1957 would have to be about $2,000. So by selling then for $1,500, we had a loss in buying power of $500. Because the Internal Revenue Service refuses to recognize a change in a dollar's value, a tax bill of $75, the same as in the original example, must be added to the $500 loss in buying power. A different tax rule on the sale of a home, is mentioned below.

Here is a third way to measure profit. Suppose that in 1940 we paid $1,000 for some shares in X Company, and in 1957 we sell this stock for $3,000, giving us a dollar profit of $2,000. During those 17 years, as mentioned above, the cost of living doubled; but our stock value has tripled. So even after paying a capital gain tax of 15 percent of $2,000, or $300, the sale looks profitable, provided we consider that the sale closes the transaction.

But ordinarily when a man sells an investment, rather than spending the proceeds he uses them to buy another investment. Suppose we reinvest by again buying the same number of shares of X stock as before, and the cost of the new stock equals what we received for the old stock, $3,000. In spite of the apparent profit, was there any sense to our selling the old stock? The new stock is not a bit better than the old, and we have voluntarily increased our federal income-tax bill for 1957. (Sometimes a man may wisely make a sale purely in order to pay a tax this year rather than later, but that is outside the scope of this chapter.)

The example just given is designed to show that when the proceeds from sale of an investment are to be reinvested, the cost of the old investment has no bearing on the wisdom of making the sale. What matters is the cost of the new investment, the replacement cost, compared to the selling price of the old one.

While it might seem like a good idea to sell a profitable stock in favor of a different one, the investor must ask himself if he really wants to pay taxes on money he's not going to see this year. The answer is usually a resounding "No."

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