There are only three ways to earn returns; interest, dividends, and capital appreciation.
In 2004, Congress designated April “Financial Literacy Month”. In celebration of financial literacy month, this is the first of four articles that focus on the four laws of investing.
In 1650, François de la Rochefoucauld wrote that “the only thing constant in life is change.” And Rochefoucauld wasn’t alone. Even though it predates Monsieur de la Rochefoucauld by over 3,300 years the Code of Hammurabi (now on view at the Louvre) said the same thing. While I didn’t know François, I wasn’t in the room when the Code was hammered into the stone, and while I don’t agree with many of the Code’s controversial 282 rules, I do know that throughout the ages, many of the world’s greatest thinkers have told us that, in life, change is a given.
On the surface, the same can be said of the investment process, where change and cyclicality are unrelenting. Markets go up and markets go down, economies crest and economies recede, interest rates move higher and interest rates move lower. Yet, amid all of the change in the investment world, four key principles have always remained the same. I call these the four laws of investing.
The first law of investing
There are three ways an investor earns an investment return: interest, dividends, capital gains, or a combination of the three.
Bank savings accounts, certificates of deposit (CDs) and bonds generate interest. Investors often choose these investments when they are interested in knowing exactly how much they are going to earn on some regular basis (monthly, semi-annually or annually).
Stocks, stock mutual funds and ETFs generate dividends. Dividends are attractive to investors because they are a form of current income and offer the potential to increase in the future. At the same time, dividends are not guaranteed and in return for assuming that risk, investors hope to be rewarded with higher dividends and the expectation that the underlying investment will appreciate in price over time.
Investors who want their investment to grow in value choose investments like stocks, stock funds and ETFs that offer capital appreciation. To benefit from an investment that has increased in value, an investor must realize the gain by selling the investment for more than the purchase price.
In addition to choosing the type of desired return, identifying the investment options that produce said desired return, and choosing the investment, investors must also choose the account in which the investment will reside.
Asset location refers to the place an asset (investment) is held. Asset location affects how income or gains from the investment are taxed. Because of that, in identifying the investments that have the potential to generate the type of returns they are seeking, an investor must also be strategic about where each investment will reside.
For example, let’s say an investor is interested in buying shares of a company that she believes has significant appreciation potential. If she purchases the stock in a taxable account and sells it for a profit, she will receive capital gains tax treatment on that profit.
On the other hand, if an investor purchases the same stock in an IRA account, the tax-treatment will be different. Although she will still make a profit on that particular stock in her IRA account, she will not receive the favorable capital gain tax treatment she received in her taxable account. Instead, all of the distributions she takes from her IRA, that have not been previously taxed, will be included in her taxable income, and taxed as ordinary income in the year the distribution is received.
Understanding investment returns and asset location are two of the most important considerations an investor must make. Once they make those decisions, they need to understand how to take full advantage of their investment returns.