Overview – How Do You Plan to Earn Money From Investing?
Unless you happen to be in it purely for altruistic reasons, you probably became an investor because you ultimately want to make money. After all, at its core investing is the act of putting down money today with the anticipation of getting more in the future.
While many investors have this objective in mind, some of them don’t stop to ask themselves a very simple yet crucial question: “how exactly do I plan to accomplish this?” This may sound like a silly question, but having a clear answer to it will fundamentally impact your entire approach to investing.
Do you plan to let your investments increase in value before selling them, do you plan to hold onto them for years to come while you collect the regular payouts that they provide, or maybe a mix of both? The sooner you have an answer to this, the better.
Making Money From Capital Gains
Very few investment instruments have static prices: the price at which you purchase one today will most likely change tomorrow, for better or for worse.
Some investors decide to wait until the market price of their investment increases before deciding to sell. The difference between the price they sold it at and their original purchase price, while also accounting for any commissions/fees that were paid, will be the amount they get to keep.
A quick example: you purchase one share of a stock for $100, and you sell it when its market price is $150. Assuming you pay a $5 commission upon selling, your gain is $45, which is the amount you pocket (before taxes).
This method of earning money in investing is known as capital gains.
Earning money via capital gains can apply to all sorts of investment instruments, whether it’s equities, real estate, precious metals, art, or even car collections.
Although making money via capital gains is theoretically possible for any investment instrument, some are better suited for it than others. For example, bonds aren’t renowned for their ability to soar in price in a short period of time, but this is entirely possible for equities (e.g., purchasing speculative equities) and some real estate investments (e.g., home flipping).
The problem with investments that can appreciate in price very quickly is that the opposite is also possible, that is, a steep price drop can also happen. In other words, volatility is the enemy of investors looking to make money through capital gains.
Not only that, but investors who do make money through capital gains will be subject to a capital gains tax. The argument can be made that a capital gains tax is designed to discourage investors from constantly selling their assets, and instead promote long-term ownership.
This may be of little concern if you plan to hold your investments for years to come, but can be a potential nuisance for those who want to sell frequently.
Making Money From Routine Payments (Dividends/Interest/Rent)
Although the price of almost all investment instruments changes on a daily basis, some of them offer routine payouts as a form of compensation to investors.
Some equities offer dividends, most bonds pay interest to bondholders, and some real estate investors earn their income not from selling a property, but by renting/leasing it out and collecting the rent/lease payments as their income.
Investors who decide to earn money this way usually don’t care as much about the daily swings in an investment’s price – as long as they continue to receive their payouts, then the price at any given moment is largely inconsequential. The only time it may matter is if an investor seeks to increase their position in a given investment, and by doing so increase their future payouts.
If investors who focus on capital gains have to worry about volatility, then the ones who focus on dividends/interest must deal with the possibility of their payouts potentially being slashed or abruptly halting.
In the wake of the COVID pandemic, many companies chose to either slash their dividends or suspend them entirely, jeopardizing the incomes of countless investors in the process.
Investors who hold government bonds from countries with lacklustre credit ratings may run the risk of their bonds defaulting, thereby losing their principal and whatever interest payments they may have been entitled to receive.
Why Does This Distinction Matter?
So, why does it matter if an investor decides to make money through capital gains or through dividends/interest? As long as an investor makes money then everything should be fine, right?
As was briefly mentioned in the introduction, how you plan to make money from investing is crucial because it will dictate your entire investing approach, such as the types of investments you pursue and the strategies you deploy.
For example, an investor who seeks to make money through capital gains will primarily focus on investments that have a very high chance of experiencing a significant increase in price. They know that the price won’t increase forever, so part of their strategy will be to decide when the right time to sell is.
Conversely, investors who are interested solely in receiving dividends/interest payments won’t care nearly as much about the price of an investment at any given time, but rather an investment’s ability to maintain its payouts. As long as the payouts keep coming, then these types of investors probably won’t sell in the near future.
If an investor owns a variety of investment instruments where some appreciate very quickly while others offer outsized intermittent payments, then their strategy will be very different from those who choose to focus on one over the other.
Notice how these approaches greatly differ from one another, and it all starts by figuring out how exactly an investor wants to make money. The end goal is still the same, yet the steps to get there vary considerably.
One approach isn’t “superior” to the others since it all depends on what an investor plans to accomplish, but regardless of what those long-term plans are everything starts with deciding how you plan to earn money, after that it becomes much easier to make the decisions that follow.
Capital Gains or Intermittent Payments? It All Boils Down to Your Investment Goals
Now that we know the two ways to earn money through investing and why this distinction matters, how does an investor choose between which method they want to go with? Again, it all comes down to what your investment goals are.
Do you plan to build a sizeable investment portfolio to support yourself in retirement, or do you plan to grow your investments as much as you possibly can within the next 10 years before ultimately selling? Are you planning to use your investments entirely for your own use, or do you plan to give them to someone else upon your death, such as next of kin or to different charities?
Choosing between capital gains or intermittent payments (or perhaps a mix of both) is important, yes, but even more important is understanding why you want to go with one or the other in the first place. Remember, your investment goals dictate what sort of strategies you want to deploy. You can’t come up with any strategies if you don’t know what it is you’re working towards in the first place.
Once you have clear investment goals in mind, making the decision between earning money via capital gains or through intermittent payments becomes that much easier to make.
Wrapping Up
Most people become investors with the intention of making money, yet some don’t know how exactly they plan to achieve that.
Broadly speaking, investors may choose to earn money through capital gains, receiving intermittent payouts, or some combination of the two. Of course, both methods come with their unique strengths and drawbacks.
Understanding how exactly you plan to make money in investing is so important because it fundamentally impacts your entire investing approach. An investor who’s focused on capital gains will have an entirely different set of strategies, interests, and thought processes than someone who is only interested in receiving dividends or interest payments.
Knowing which of the two methods to go with, or what proportion you wish to combine them, will ultimately depend on what your investment goals are.
