This is what cost basis means when buying stocks — and why we (usually) don't violate it

Published Thu, Feb 9 20238:59 AM EST

You'll often hear Jim Cramer say that we don't want to violate our cost basis when adding to one of our Club positions. What does that mean exactly? Here's a closer look at our cost-basis rule, why we hold it in such high regard, and a couple of exceptions. First, a pair of investing terms. A "lot" is the number of shares and the purchase price for any trade. Future buys generate new lots. The "weighted average cost basis" (or cost basis, for short) is calculated by multiplying the average share price of each lot by the percentage of the total position size which that lot represents and adding them all up. When Jim says that our discipline forbids us from "violating our cost basis," he means we want every new buy in a stock we own to be below the weighted average cost basis. If we're abiding by this rule, that also means that every new purchase as we build a position is made at a price point lower than the previous purchase. As a result, each new buy should serve to reduce the overall weighted average cost basis of the position. For example, if our first purchase of a stock was made at $100 per share, we strive to make subsequent buys at some levels below that — say at $95, then at $90 and so on. Assuming we purchased 50 shares to start and 25 shares in each subsequent purchase, our cost basis in this instance would move from $100 (50/50 or 100% of shares at $100) to $98.33 (50/75 shares or 67.67% at 100 and 25/75 or 33.33% of shares at $95). A third stock purchase of 25 shares at $90 would take the cost basis to $96.25 (50/100 or 50% of shares at $100, 25/100 or 25% of shares at $95, and 25/100 or 25% of shares at $90). Most brokerage tools calculate this for you, usually in the "cost" column or "cost basis" column in the dashboard. If nothing has changed our view of the company's fair value, every new purchase should increase our potential upside by reducing our cost basis. If our target for what we think a stock is worth is $120 per share, we had 20% upside from $100, 23% upside from $97.5 and just over 26% upside from the $95 level. By following this rule to not violate our cost basis, each new lot we purchase is a better value than the previous one — assuming, of course, there has been no change to our underlying investment thesis. Earnings have stayed the same, but the stock price has fallen, meaning a lower price-to-earnings ratio — one of the key measures Wall Street uses to value companies in relation to peers and the broader market. If we do buy a position and it runs on us before we were given the chance to build it up at progressively lower price points, our inclination is to let it run. Though in some isolated instances — like when our initial purchase was especially small, think sub-1% of the entire portfolio, or we were lucky enough to nail a bottom — we may opt to add to the position if it's hovering at around the same level. That's what we call a "high-quality problem," not to be too down about. There are two valid exceptions to the don't-violate-cost-basis rule when we buy shares at a higher price than our average cost basis. The business prospects of the company are improving. When this happens, it's important to acknowledge that while a stock price may have increased, the valuation may not have. The valuation may have even gone down, in which case you may be paying a higher stock price but getting an equal or greater value than you did previously. Remember, price is only one part of the P/E and it's what you pay. Value is what you get. You're rebuilding a position. In this scenario, we focus a little bit less on the basis of our existing position and more so on the price at which we sold the shares we are looking to buy back. We still wouldn't do it all at once though. Scaling in slowly above your basis might make sense if the stock has come way down from your last sale. Though you may be violating your existing cost basis, the thinking is that you are essentially sucking money out of the market if you sold shares higher and are provided the opportunity to rebuild in a position you still think has long-term upside. To illustrate that second exception, if position XYZ has a basis of $100 per share and we previously sold shares at $150, we may be looking to buy those shares back around $120 — depending, of course, on the cause behind its decline from $150 to $120. Sure that would be a violation of our cost basis but that $120 level would also represent a 20% drawdown from where we previously sold shares. This is especially true for long-held positions that may never provide you the opportunity to repurchase below basis. Here's a recent real-world example concerning our long-term holding Nvidia (NVDA). We sold 200 shares at around $222 each in April 2022 ahead of the bulk of the market slide on the then-tightening Fed monetary policy to fight inflation. We repurchased 50 shares at around $173 in May 2022 and another 25 in August 2022 at around $150. While these re-buys were above our existing basis, they were well below the sale price of the initial 200 shares. We used that initial price as our reference point to justify rebuilding the position above the basis seen in our portfolio. Obviously, trimming a long-term position can also affect your cost basis in the holding. We don't have any hard and fast rules on when to sell. It's more of an art than science, and we've written about when to sell winners and the questions we ask ourselves before we sell losers. We don't get hung up on how that might affect cost basis because the reason for selling takes precedence. (See here for a full list of the stocks in Jim Cramer's Charitable Trust.) As a subscriber to the CNBC Investing Club with Jim Cramer, you will receive a trade alert before Jim makes a trade. Jim waits 45 minutes after sending a trade alert before buying or selling a stock in his charitable trust's portfolio. If Jim has talked about a stock on CNBC TV, he waits 72 hours after issuing the trade alert before executing the trade. THE ABOVE INVESTING CLUB INFORMATION IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY , TOGETHER WITH OUR DISCLAIMER . NO FIDUCIARY OBLIGATION OR DUTY EXISTS, OR IS CREATED, BY VIRTUE OF YOUR RECEIPT OF ANY INFORMATION PROVIDED IN CONNECTION WITH THE INVESTING CLUB. NO SPECIFIC OUTCOME OR PROFIT IS GUARANTEED.

Carlo Allegri | Reuters