What is the Difference between Investment Income and Capital Gains? Which is better?
The reason we invest money is to end up with more money than we started with - to make a return on our investments. Broadly there are two ways of doing that:
- getting an income from the investment, or
- making a capital gain.
To understand the difference between investment income and capital gains it helps to understand how investment works.
How investment works - the big picture
When we invest, we are giving our money to someone else (usually a company) to use for something productive. They then make money from whatever they are doing, hopefully enough to pay us either our money back with interest (if we gave them a loan or bought a bond) or to pay us a share of the profits as a dividend (if we bought a share in the business).
The money invested is "capital" and the money paid out by the company as interest or dividends is our "income".
Understanding the difference is important for understanding the components that make up the return on our investments. And if you can't understand it, you can't manage it.
Investing in different asset classes
What is a capital gain? How does compare to income?
Income is easy to understand - it's the money we are paid by our investments (although you often have the option to reinvest that money rather than taking it as cash now). But what is a capital gain?
Remember capital here is the money we put into the investment. With some investments (like a savings account) you can just withdraw the capital and it will be worth the same as when you put it in. But for other investments like bonds or stocks or shares the you typically have to sell your investment to get the money back. That means that the price you get might be more or less than what you originally put in. If it's more, that is a capital gain (and if it's less it's a capital loss).
To put it even more bluntly: Capital gains aren't really yours until you sell. You may have an asset that is worth more on paper, but the only way you can cash in is to sell at the market price, assuming that there is anyone willing to buy. Fortunately for "high quality" stocks or bonds there is usually a pretty efficient market, so you have a fair idea of the price you will get. But if you invest in hard to value things like property or artworks you may have difficulty knowing how much you will get until the sale is over.
So what's the difference between income and capital gains?
The big difference is that the income is paid out by the company you have invested in, as savings interest, bond interest payments or as a dividend. But capital gains happen because the market price for an investment has gone up. In other words it is based on the opinions of other investors.
In theory, if markets work properly, then the market price of the investment should be equal to the risk adjusted present value of the all the future possible income from the investment. So, again in theory, income and capital gains should just be two sides of the coin - just different ways of getting you a return on your investment.
But in practice market prices vary quite a lot. This means that generally income has a more stable and predictable cashflow, compared to depending only on capital gains.
On the other hand if you are reinvesting your money rather than using the cashflow immediately it may be simpler and more tax efficient to receive a capital gain rather than income.
Which is better - capital gains or income?
There is no simple answer to that question. It depends on your situation, on what you want and need from your investments.
If you are going to take your investment returns to live on rather than reinvesting them, then you are probably better off with investments that have relatively high stable incomes, like corporate or Government bonds, or dividend paying stocks and shares or property. This is because you will have more certainty over your actual cash-flow - the money actually paid to you
On the other hand if you are only interested in long term capital appreciation, and are happy taking risks you may be better off investing in assets that may give you a high capital gain, such as non-dividend paying stocks and shares, or commodities such as gold.
However there are a lot of other factors that will affect your returns from these different asset classes so you can't just think about whether you prefer income or capital gains. For example don't forget that most of the time higher return investments come with higher risk - this isn't a necessarily a problem so long as you understand the risks you are taking and are comfortable with them. This is something you may wish to take personal financial advice about, as everyone's circumstances will be different.
Income and capital gains are also taxed differently. In recent years many countries have made capital gains less taxed than income, which is one reason many investors now prefer capital gains. However this is a complex area and you should check out thoroughly the rules that apply wherever you are.
Income and capital gains are both ways of receiving a return on your investments. Assets that focus on income are generally more stable and assets the focus on capital gains are often more exciting. But the important point is to find investments that meet your needs, whether that is money now or growth for the future, and then get as a good a return on your investments as you can.
For an overview of the things you really need to understand about your investments take a look at this article here.
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