I've had a few comments regarding the accounting used for the portfolio changes reported earlier this week. I've already replied to those comments but thought I would also post it in a separate article.
The most common comment I've received is
"why not just take the loss and start the new positions with available cash? Is it perhaps due to an aversion to loss and carrying the loss forward is just a way to hide the losses?".
These are legitimate questions which I'll try to address in this article. First, let me start by saying that I do not have an aversion to loss nor am I trying to hide the losses. The losses are already accounted for in the market value of my account, which is posted here every month. This is the information provided by my brokerage statement.
If you're a capital appreciation investor, your brokerage statement is all you need to determine whether or not you're meeting your investment goals. Each year all you need to do is compare the balance at the end of the year with the balance at the beginning of the year. If the ending balance is higher than your goal, then your goal was achieved.
However, if you're an income investor, your brokerage statement doesn't tell you what you need to know, which is how much yield you earned on the invested capital.
Let me provide an example. Say I start the year with $10,000 of working capital and decide to buy 200 shares of XYZ at $50/share. During the year I earn $1,200 of income from dividends and option premiums. At the end of the year XYZ is worth $40/share, for a decline of 20%. Here's how the brokerage statement would report this.
Market Value from Brokerage StatementStarting Value: $10,000
Ending Value: $9,200
Total P/L: -$800
Market Value Return: -8%
If my goal was capital appreciation, this is all I would need to know, and it clearly shows I didn't achieve my goal.
However, I'm an income investor, and nowhere on the brokerage statement does it tell me about the yield I earned on the original $10,000, and whether or not I achieved my goal. So, I have to track this myself and here's how I would report this.
Yield on Working CapitalStarting Working Capital: $10,000
Ending Working Capital: $11,200
Total Income: $1,200
Working Capital Return: 12%
So, clearly two different accounting methods must be used here to determine if my goals were met.
Now, say I decide to sell 200 shares of XYZ at $40/share and buy 200 shares of ABC at $40/share. My Market Value, as reported by my broker, would remain the same.
Market Value from Brokerage StatementStarting Value: $10,000
Ending Value: $9,200
Total P/L: -$800
Market Value Return: -8%
But what about my Yield on Working Capital? Some suggested that I reduce my working capital by the $800 loss, rather than carry the cost basis forward. Let's see what that would look like.
Yield on Working CapitalStarting Working Capital: $10,000
Ending Working Capital: $9,200
Total Income: -$800
Working Capital Return: -8%
Look familiar? That's the same as the brokerage statement. So doing it this way I lose all the information regarding Yield on Working Capital and my ability to determine if I'm achieving my yield goal or not. Also, it makes no sense to have the same figures reported twice. I need both sets of figures to track my performance from a capital appreciation and income generation standpoint.
So I hope this helps explain my rationale. Again, this has nothing to do with loss aversion or hiding loses. It's simply a method for me to track Yield on Working Capital, since my broker doesn't provide that information.
