How do you treat investment income?

cloud_dog

I have a query on how you treat investment income in relation to your investment return.

If you receive dividend income as cash then this is a mute query but......

If you automatically reinvest dividends or income from UTs (etc) how do you treat the effect that has on your overall performance or cost of investing?

If you purchase a stock for £2k and receive £50 dividend which is automatically reinvested and for the sake of round numbers buys you another 10 shares.

Those 10 shares have cost you nothing so, in theory, your average buy price is reduced and therefore your overall return increased.

And it is this aspect I am keen to understand what people do, if they do anything?

In MS Money which I use to manage investments it treats it as a purchase of £50 so the average buy price is updated based on an additional £50 being invested.

Which in one sense is correct but as the £50 didn't actually cost me anything it should be treated as a null purchase and reduce my average buy price.

So, what d'ya do?

Linton

cloud_dog wrote: »

I have a query on how you treat investment income in relation to your investment return.

If you receive dividend income as cash then this is a mute query but......

If you automatically reinvest dividends or income from UTs (etc) how do you treat the effect that has on your overall performance or cost of investing?

If you purchase a stock for £2k and receive £50 dividend which is automatically reinvested and for the sake of round numbers buys you another 10 shares.

Those 10 shares have cost you nothing so, in theory, your average buy price is reduced and therefore your overall return increased.

And it is this aspect I am keen to understand what people do, if they do anything?

In MS Money which I use to manage investments it treats it as a purchase of £50 so the average buy price is updated based on an additional £50 being invested.

Which in one sense is correct but as the £50 didn't actually cost me anything it should be treated as a null purchase and reduce my average buy price.

So, what d'ya do?

In MS Money, if you classify it as reinvestment of dividend the "gain" and "return" increase by the amount of the dividend and the average price changes as you say. Surely this is correct - its the same as getting the £50 dividend in cash and then using it as a separate transaction to buy more shares at the current price.

cloud_dog

Linton wrote: »

In MS Money, if you classify it as reinvestment of dividend the "gain" and "return" increase by the amount of the dividend and the average price changes as you say. Surely this is correct - its the same as getting the £50 dividend in cash and then using it as a separate transaction to buy more shares at the current price.

Hi Linton

You are correct that the gain is positively affected but the dividend is still added to the 'cost' of your holding which is where I trying to reconcile the pro's and con's of the way its done.

Again, you are correct that if I'd taken the £50 and invested it elsewhere the cost of investing would have been £50, when in reality, to me, it was free money.

Automatically reinvesting the 'free money' in theory could reduce the the cost of the (overall) investment cost, thereby the average buy price would be enhanced.

EDIT: Who knows I'm just sat here waiting for the food to be delivered

Chargem

cloud_dog wrote: »

Hi Linton

You are correct that the gain is positively affected but the dividend is still added to the 'cost' of your holding which is where I trying to reconcile the pro's and con's of the way its done.

Again, you are correct that if I'd taken the £50 and invested it elsewhere the cost of investing would have been £50, when in reality, to me, it was free money.

Automatically reinvesting the 'free money' in theory could reduce the the cost of the (overall) investment cost, thereby the average buy price would be enhanced.

EDIT: Who knows I'm just sat here waiting for the food to be delivered

I agree it's confusing but I think the reinvested dividend has to be a cost, because getting those shares did actually cost you something (you could have had £50 cash instead, which you could have spent or invested in something else)

bowlhead99

Lets say the shares (including reinvested dividends) are currently worth £3,050 and due to a great performance next month they double to £6,100 and are sold.

Your lifetime Total Return on the investment is the final proceeds £6,100 less original cash investment cost of £2,000. You achieved £4,100 total return, total proceeds were 3.05x cost. Nice investment.
Looking at how you might be accounting for it:

A) If you had recorded the dividend as free new shares at nil cost, your pot of shares would have a cost base of £2000 and proceeds of £6,100 = £4,100. This £4,100 is "profits" and agrees with the Total Return expected, but you havent tracked the nature of it (i.e. how much is income, how much is capital gain).

If you had recorded dividend income of £50 and the new shares at £50 cost, you would have a cost base of £2,050 and proceeds of £6,100 = £4,050 "capital gain". The capital gain plus the separately tracked dividend income equals the £4,100 profit in (A) and the Total Return we were expecting, but gives you more detail.

This detailed split of income return versus capital return is useful ; income and gains have different tax rates and annual exemptions, and in some years the income could be positive while the capital is negative.

When it comes to making tax returns, or making decisions over whether to hold this investment inside or outside a tax wrapper, or assessing the level of ongoing income which could be easily diverted to other investments or your living expenses, instead of auto-invested, it is better to have tracked the detail. This is why it's done the "method B" way in MS Money, and why accounting standards force companies to account for activity to this level of detail in their audited financial statements.

If you don't need to do tax returns for this income, or need/want to use the performance information in any decisions, then you can make your life simpler and lose the detail. However given MS Money tracks it for you anyway (you're not just tracking it on sheets of paper), there's no reason to look for a shortcut.

Totton

Alternatively in MS Money you can select 'Add Shares' so that any new amount of units/shares are invested from the dividend as a null amount and thus get reflected in the average cost correctly.

I prefer to add the dividend as a sum in and then purchase new amounts in the normal way, this ensures that I get the correct performance figure plus can create a report of all dividends received.

It is a real shame that MS Money was discontinued, I have yet to find anything similar that gets close to it, I am still using the program but have lost the automatic updating of prices :-(

Chargem

Totton wrote: »

It is a real shame that MS Money was discontinued, I have yet to find anything similar that gets close to it, I am still using the program but have lost the automatic updating of prices :-(

I assume that MS Money was discontinued despite having no real competition because it wasn't commercially viable, I think that's a sad reflection on society today - people don't want to track their finances.

Masomnia

I see what you're getting at. Halifax brokers does what you say in that it adds a reinvested dividend as a purchase.

I bought £1000 in BP shares a bit ago, had £18 in dividends reinvested, however the value of the original amount has fallen a touch. In total my holding is worth £1012. Halifax reckon I'm down £6; but I'm not really, I'm up £12 as I've only paid £1000.

I don't really care enough to worry too much about it, TBperfectlyH.

cloud_dog

Its a situation where you cannot achieve both so I'm sure they way most system do it is appropriate.

I was curious from an annual income return perspective because over the long-term, assuming you make a single initial purchase with all income/divi's reinvested your income P.A. as a percentage of the initial investment (don't want to use the term Yield) could be excellent, leaving one with a very smug look on their face

King_Weasel

If MS Money is no longer available and there are no other similar packages, is it such a problem to write your own in Excel or equivalent?

bowlhead99

cloud_dog wrote: »

I was curious from an annual income return perspective because over the long-term, assuming you make a single initial purchase with all income/divi's reinvested your income P.A. as a percentage of the initial investment (don't want to use the term Yield) could be excellent, leaving one with a very smug look on their face

Sure, you can eventually see a fantastic "income per annum as a percentage of initial investment" but like you say, it's not true yield and is relatively less useful for decision making.

Imagine having 100 shares bought for £1 each and £100 total, which generally each pay 10p dividend each year and you reinvest them to buy a tenner's worth of new shares. This builds up over the years and at some point you will end up with 200 shares. By this point, with the company being successful and the effects of inflation etc, each share is paying a 15p dividend and in total your 200 shares pay you around the £30 range each year, which is a 30% return on the original amount invested, leaving you with the smug face.

By this point the 200 shares are now valued at £5 each, total value £1000. The share price growth seems to have flattened off and analyst consensus is it is not going to go up anytime soon. You've made a 10x return on your £100 so are pretty damn happy, and you consider your options.

Should you sell? You look at what else is on the market. You smile to yourself as you see that no companies or funds are yielding anywhere near 30%! Wow this is a solid investment. I'm an awesome stockpicker. Half of these shares were just from dividends and didn't cost me anything! I only paid £100 so 90% of this investment value is just free money! I love this stock. Even if it goes down, most of it was free and I'm happy to ride the ups and downs because I was told stocks are not a one way street. But most importantly I'm making 30% for doing nothing, and there's no investments out there yielding more than 10% at the moment! No way I'm selling this baby!

Clearly of course the £30 return on a £1000 investment is only a 3% yield and may well be beaten by a completely risk free cash ISA or national savings bond.

The 30% annual return on original investment is good for the ego but is really just a curiosity. It's the 1000 vs 100 historic total return which tells you whether it was a good performer in the past, and the 30 vs 1000 current yield which tells you what income it's really producing against other opportunities.