How are we going to account for this thing?
Imagine for a moment that you are setting up a mutual fund. No, not one of those underperforming wonders Wall Street churns out all of the time. It will be your own, personal fund. All you need to do is figure out how many shares to start with and start buying stocks. Every time you add money, you simply buy new shares at the market close.
Why do this share nonsense? When you are putting money on a regular basis, it is unfair to count the money as if it had been there for the entire period. If you start with $500 and put in $100 a month for 12 months, you will have put $1,700 into stocks. But a good portion of that money will have been invested for less than six months, meaning it would be difficult to earn any kind of return on it. On the other hand, that initial $500 will have been in the market for a year and it will have definitely done something.
If you just judge performance on the total value versus the amount of money you put in, you will constantly be weighting the money you put in recently more than the money that has already been sitting there. This means if you have done poorly, your performance will look better, but if you have done well, you performance will look less auspicious. The share price accounting method allows us to smooth this out by weighting each dollar equally as we convert it into shares.
Sound devilishly simple? It certainly is. It is the share-price account method and it will be what we use to account for the ol' Drip Portfolio. Let's explain it using the portfolio as an example.
Day one we put $500 smackers into the Drip Portfolio. As of that day, we arbitrarily decided that we will have 20 shares. This means that on day one, before we spent a single dime, our 20 shares were each worth $25.
Total Value $500
Per Share Value = ----------------- = -------- = $25
Shares Out 20
Now, we started the Drip Portfolio on July 28th. On August 15th, we added our first $100. In the intervening time, we paid $40.50 for a subscription to the MoneyPaper, leaving us with $459.50. How do we work the purchase?
Before we added the $100, each share of the Drip Portfolio was worth $22.975.
Total Value $459.50
Per Share Value = ----------------- = ------------ = $22.975
Shares Out 20
Now, with that $100 we added, we bought 4.35 shares.
Money Put In $100
New Shares = --------------------- = ----------- = 4.35
Price Per Share $22.975
So, on August 16th we had 24.35 shares worth $22.975 apiece. Our performance since inception had not changed a whit because of the money added. However, we had added $100, meaning that the actual performance will be fully reflected -- after paying all fees and commissions. This means that the Drip Portfolio will probably be down 10% to 15% in the first year as we will pay a lot of fees getting our first shares. However, after that, we expect to pay very little in the way of fees and over time we expect to more than make up for our initial costs.
Now, on September 8 we bought our first share of Intel, which cost us $109.69. We deduct this $109.69 from our $559.50 in cash to leave us with $449.81 in cash and one share of Intel. As Intel was worth $94.69 on that day, our per share value was:
Total Value $449.81 + $94.69
Per Share Value = ----------------- = ------------------------- = $22.36
Shares Out 24.35
The next transaction was on September 15, when we added another $100. With our one share of Intel at $92.06 on that day, our total value that evening was the $449.81 in cash plus the $92.06 in Intel, or $541.87, with 24.35 shares out. This means our buy-in per share value was $22.25, so we added 4.47 shares. This increased our cash balance to $549.81 and our shares outstanding to 28.84. We can see from below that even though cash went up, because we increased the shares we actually kept things stable.
Total Value $549.81 + $92.06
Per Share Value = ---------------- = ------------------------- = $22.27
Shares Out 28.82
Our next transaction was to add another $100 -- creating 4.49 more shares for a total of 33.29. We will also be receiving dividends that we will automatically reinvest, meaning we could find out we have 1.002 shares or somesuch as the dividends will be small to start.