It's a tax issue. The IRS is really interested in how many gains or losses you make on your mutual funds, stock purchases and other investments because they want to be sure to tax you on your gains. The average cost basis is one way to arrive at an answer.
Basically, you tally up everything and divide by the number of shares to get the number. Example: You liked AT&T at $40 a share. You bought 500 shares. You liked it even more at $35 and bought 1,000 shares. You loved it at $30 and bought 2,000 shares. You adored it at $25 and bought 5,000 shares. Add up the total shares you purchased and figure out the total you paid for everything. Then divide the amount you paid by the shares you have. That gives you an average cost basis is $28.24 (forget commissions).
The stock then went to $50 and you sold half your holdings, or 4,250 shares. How much gain was there? Well, you take the average cost in for half of your shares, and you match it with the average cost out. In this case, you are realizing gains per share of $50 - $28.24 or $21.76 x 4,250 shares or $92,480.
Related or Semi-related Video
Finance: What is Average Down?8 Views
Finance, a la shmoop what is average down or dollar cost averaging well remember the
movie Black Hawk Down, Navy SEALs who were shot down in Somalia then bravely [Solider shooting a rifle]
shot their way to safety until they ran out of bullets yeah [Guy looks upset that he's out of ammo]
well that has nothing to do with average down although you'd think it was an [Guy holding popcorn in the theater]
anthem for how we select politicians in this country but we digress when you
average down you thought you were oh so clever in paying eighty two dollars a
share for slip and slide roof shingles sounded like a real winner at the time
well the stock could hit par or a hundred bucks a share and not really par [Guy sliding on some roof tiles in the rain]
but it just sounds cool when equity investors call out par for an equity so
the stock was 100 bucks and you believe the brokers you were sure it'd be [Clock ticking by]
two hundred dollars in two years so you bought and then they missed their next
quarter and then their next you still are a big believer in the stock if you [Girl looking unhappy at the newspaper]
weren't you would take your losses but if you had conviction at eighty two
dollars a share well you still have conviction it'll get to $200 soon right
all right so now the stock sits at 47 bucks a share and you buy another [Stock price chart showing the price going down]
hundred shares to add to the hundred you paid eighty two dollars a share for
seven months ago and then they miss another quarter and you buy another
hundred shares now at the bargain basement price of $35 a share well you
bought in three separate tranches each one cheaper than the next the first one
cost you 100 times eighty two bucks or eighty two hundred dollars, nice job
buying there... second tranche cost you 100 times 47 bucks or 47 hundred dollars [Working being written out]
and applying concepts beyond calculus here the third tranche cost you a
hundred times thirty-five dollars or thirty five hundred dollars well what
did you do you averaged down your initial cost from 82 bucks a share to a final
average cost of 82 hundred plus forty seven hundred plus thirty five hundred
divided by three hundred shares you own which is about 54 sixty-seven a share
your dollar cost average then is $54 sixty-seven cents and you should also
note that although the number one reason to average down is because you're a [Guy sat on a roof]
believer in the stock long term, a second more Machiavellian reason at least if
you're a professional money manager is that it looks a whole lot
better when you report to shareholders that you bought in at a lower average
price when eventually it goes up again so nice going there would be Warren B [Stock price going up again on the chart]
let's hope that SNS shingle starts including an inflatable rescue mattress [Boy sliding down the roof]
with every purchase and every quarter they report [Boy flies off the roof, into a tree and then falls to the floor]
Up Next
What is Cost Basis? For accounting purposes, the cost basis is the amount invested at the time of asset purchase. That is subtracted from the sale...
Tax basis is your cost for assessing how much you owe in taxes, and is determined by multiplying your gains by your tax rate.