An "increase profit," in business or investing, is usually defined along this line: The selling price of an item, less its cost and expenses, is an increase profit; or if selling price is lower than cost plus expenses, the difference is "loss." Suppose we buy an invest­ment for $1,000, including buying expense, and sell it for a net of $1,500, after deducting selling expense. Customarily we say we have a profit, before tax, of $500; and if we pay a 15 per cent Federal capital-gain tax of $75, our profit after this tax is $425. Within certain limits, these statements may be correct, but they can be quite deceptive for a long-term investor.

Here is the queer part. Before determining whether we have an increase profit or loss, and how much, we must adopt some standard way to measure the value of cost and sale. People generally take it for granted that the dollar is the proper standard for measuring, as in the example above. The Federal Government compels a taxpayer to use this standard in figuring the tax on a capital gain or loss. But presumably a man does not engage in long-range investing merely to collect dollars; what he is aiming for is future buying power. From this viewpoint, a sale of an investment is profitable to the extent that it gives him more buying power than he paid in when he bought.

Suppose we paid $1,000 for an investment in 1940 and sold it for $1,500 in 1957. During the intervening seventeen years, according to the U.S. Government's index of consumer prices, the cost of living just about doubled. To make a sale that would give buying power equal to $1,000 in 1940, the price in 1957 would have to be about $2,000. So by selling then for $1,500, we had a loss in buying power of $500. Be­cause the Internal Revenue Service refuses to recognize a a change in a dollar's value, a tax bill of $75, the same as in the original example, must be added to the $500 loss in buying power. A different tax rule on the sale of a home, is mentioned below.

Here is a third way to measure profit. Suppose that in 1940 we paid $1,000 for some shares in X Company, and in 1957 we sell this stock for $3,000, giving us a dollar profit of $2,000. During those seventeen years, as mentioned above, the cost of living doubled; but our stock value has tripled. So even after paying a capital-gain tax of 15 per cent of $2,000, or $300, the sale looks profitable, provided we con­sider that the sale closes the transaction.

But ordinarily when a man sells an investment, rather than spending the proceeds he uses them to buy another investment. Suppose we reinvest by again buying the same number of shares of X stock as before, and the cost of the new stock equals what we received for the old stock, $3,000. In spite of the apparent profit, was there any sense to our selling the old stock? The new stock is not a bit better than the old, and we have voluntarily increased our Federal income-tax bill for 1957. (Sometimes a man may wisely make a sale purely in order to pay a tax this year rather than later, but that is outside the scope of this chapter.)

The example just given is designed to show that when the proceeds from sale of an investment are to be reinvested, the cost of the old investment has no bearing on the wisdom of making the sale. What matters is the cost of the new investment, the replacement cost, compared to the selling price of the old one.

Curiously enough, on one kind of property Federal income-tax rules conform to the principle of measuring increase profit by replacement cost, thus contradicting their rules on sales of other types of property. When a man who owns the house he occupies sells it and buys another one promptly, paying more for it than he did for the old one, he can use the cost of the new home rather than of the old one in figuring his capital gain on the sale of the old house. Suppose the old house cost $10,000, was sold for $20,000, and the new one costs $19,000. The capital gain, for Federal income tax, is the old house sale value, $20,000, less the new house cost, $19,000, leaving a gain of only $1,000.

Returning to our purchase of shares of X Company in 1940 and selling them for $3,000 in 1957, suppose that after the sale we held the cash until 1958, and then, taking ad­vantage of a drop in the price of this stock, we bought back, for $2,000, the same number of shares we had sold. Once again, our 1940 cost has no bearing on the wisdom of the sale in 1957. We might say the sale was profitable because the 1957 selling price was enough higher than the replace­ment cost in 1958 to more than cover the capital-gain tax and the dividends we missed during the year we did not own the stock.

Now let's make our stock transactions a bit more compli­cated. Suppose that after we sell the shares of X Company for $3,000 in 1957, we reinvest all of the proceeds by buy­ing shares of Y Company. Is the sale of the X stock profit­able? Assuming we are the sort of person who thinks before acting, we have some reason for believing it better to re­place X with Y stock; but at the time we make the switch, it is impossible to know definitely whether there will be an increase profit or not.

Whether the switch is wise depends upon what happens in the future. Suppose that after owning the Y stock for a year, we sell it in 1958 for $2,500, $500 less than we paid for it. Looking just at the Y stock, we have a loss of $500. But suppose we had kept the X stock, and at the time we sold the Y stock for $2,500, the value of the X stock had dropped to $2,000. By switching from X to Y in 1957, we might say we found out, a year later, that we had made a profit of $500.

By this time we hope it is evident that when we sell an investment, so long as we continue to reinvest we cannot obtain a definite and final answer to the question of whether we made a profit. If an answer ever materializes, it will be when we die or dispose of all our capital. So we suggest that while the words "increase profit" may have some meaning for a short-term speculator, it has little significance for a long-term investor, and he might as well forget it.

If the measuring of increase profits is impractical, and perhaps mis­leading, then how can a long-term investor judge whether his performance record is good, bad, or indifferent? An an­swer to that question is given in the chapter headed "By What Standard to Judge Results in Stock."