Investing 101: All about capital gains, capital losses and dividends
WASHINGTON. In the previous episode of Investing 101, we took a close look at common stocks. Conservative, carefully chosen investments in common stocks can help you accomplish your financial aims by offering two attractive outcomes: capital gains and dividends. Of course, you can also sustain capital losses as well. That’s something we’ll discuss a bit later in this article.
Common stocks generally constitute the bedrock holdings in most investing portfolios, at least for most investors between the ages of 22 and 60. These are the years during which most investors want to maximize growth in both individual portfolios and 401(k) accounts. That’s in addition to any IRAs or Roth IRAs those investors they might hold as well.
People invest in stocks, at least in theory, to generate larger returns than they’ll get in any bank account. That includes CDs, at least at their current rates of return. Just keep in mind: unlike the money in your bank account, brokerage accounts holding individual stocks and other investments can also lose money as well as making it.
That said, if the object of the game is to make money, at least most of the time, there are two basic ways to make money in common stocks.
- You make money if a stock in your portfolio increases in value. That enables you to sell it at a profit.
- Many stocks also pay dividends while you wait for them to increase in value. In other words, dividends can make you money you hold those shares of stock, waiting for those shares to appreciate in value.
Capital gains (and losses)
If you buy a bank CD, you expect to get your original investment – your principal – back on its date of maturity. At the same time, you will also receive the full and/or final amount of interest you’ve earned. Interest being defined as a certain percentage of your original investment.
But once you purchase shares of common stock, those shares will fluctuate in price, sometimes considerably, for as long as you hold them. Unlike CDs, shares of common stocks don’t “expire” or “mature.” They just keep on trading, up or down, whether you own any shares or not. If you do own them, you (generally) hope they’ll go up.
(Disclaimer: Throughout the rest of this series of articles, you’ll see a lot of hedge words, like “generally” in the previous sentence. That’s because nothing is guaranteed in the investment world. Stocks, bonds and many other instruments will fluctuate in unpredictable ways. So, based on my own professional experience, I’m trying to tell my readers what usually happens, what should happen or what often happens. But stocks and bonds fluctuate. Meaning that what we expect to happen sometimes does not. Hence, the hedge words. Investing always involves a degree of risk. So nothing is guaranteed.)
If you choose your stock investments wisely in terms of value, your stocks may indeed rise in value (i.e.,price) over time, enabling you to sell at a higher price. Your profit is called a capital gain. In other words, you invested a portion of your capital and increased your wealth when you sold your investment at a higher price. Hence, the term, capital gain. You have “gained” more capital.
Short- and long-term capital gains
If you’ve held your profitable stock for less than a year and then sell it, current tax law regards it as a short-term capital gain. Such gains are taxed as ordinary income, with Federal and state rates of taxation determined by your personal tax bracket.
If you’ve held that profitable stock for over a year and then sell it, your gain magically become a long-term capital gain. Such gains are taxed at the prevailing capital gains tax rate. That rate, always a hot topic in Congress (where the rate is regularly changed), historically offers more favorable tax treatment than short-term capital gains.
BTW, leftist college economics professors notwithstanding, reaping short and long term capital gains in your investment account(s) makes you a capitalist, albeit a rather small capitalist. That’s true even if you’re making money by choosing various mutual funds available in your company’s 401(k) plan. So, if you’re investing in the stock market, you are now an actual capitalist, no matter what TV pundits and politicians may tell you. That’s because you’re earning money by putting your excess capital to work. This game is not just for “the rich.”
“Earned” and “Unearned” income
Oddly enough, the IRS regards money you earn through your investments to be “unearned income.” Go figure. Didn’t we all have to earn it before we invested it?
In many ways, this way of earning money — investing — is better (and more fun) than wielding a pix-axe or cranking algorithms from 9 to 5, five days a week, for a manager of sub-average intelligence, à la Dilbert. The money you’re paid for that kind of work, of course, is defined as “earned income” by the IRS.
Short- and long-term capital losses
Again a reminder: You can lose money in those shares of common stock as well. Investing plans don’t always work out. (Ask our current President how his investments in Atlantic City real estate worked out for him.)
Yes, just as you can reap capital gains, you can sustain capital losses if you sell your underperforming stock for a loss. Capital losses, like capital gains, are also short-term and long-term. In case you lose money on a stock, taking a short-term capital loss can be a greater tax advantage than taking a long-term capital loss, depending on your tax bracket.
But let’s leave that issue here right now. We’ll get back to how taxationworks in a future installment.
Suffice it to say that for now, if you’re going to take a capital gain, you’re usually better off taking it long-term if you can. Whereas if you’re going to take a capital loss, you’re usually better off taking it short-term. Remember: your mileage may vary.
Dividends are the second way you can make money on your shares of stock.
Your bank pays you interest on your money. Your bonds and CDs also pay you interest. But stocks pay dividends. To use one of my favorite phrases from an old Cheech and Chong movies, dividends and interest are the same, only different. Both pay you a percentage return on the value of your investment. But a common stock dividend’s rate of return may fluctuate up or down, while your bank, CD or bond interest rate usually does not.
Most important of all, the IRS treats dividends and interest differently when you report them on your tax return. The new GOP tax law may cause some changes on your upcoming 2018 1040 forms — if indeed you will still be filing them — but they are separate line items on the form and are treated differently, tax-wise. A(gain, more later in this series on taxes.)
Why are dividends important?
For me, at least, given today’s chaotic markets, a decent dividend is a very important reason for investing in high-quality and (hopefully) high-yielding (high dividend-paying) stocks. That’s because, while the price of any stock will vary daily and sometimes quite dramatically, you’ll still get a relatively predictable dividend every quarter unless your company gets itself into a world of trouble.
A common stock dividend means the company is paying you, usually quarterly, to hang onto its shares for the long haul. Older investors tend to regard dividends as a kind of supllemental income. And if that income keeps coming in even during a bad patch in the stock market, most investors make at least some money in the short term via dividends while they wait to achieve that capital gain in the longer term. The dividend incentive may help diminish your temptation to sell your stock for a loss when times are tough.
Stocks that don’t pay dividends vs. those that do
Not all stocks pay dividends, of course. Mature companies are the most reliable dividend payers. Well past their high-growth early years, they are more boring than today’s hot tech stocks. The don’t always appreciate a lot, or at least not rapidly. But for conservative investors, they tend to be more reliable as a source of income and, eventually, long-term profits. In other words, these mature company stocks may not give you bragging rights. But they can help you sleep better at night.
Many U.S. companies in the long-time dividend paying category have been around longer than your grandfather. We’re talking about well-known corporate giants like Johnson and Johnson (ticker symbol: JNJ), Proctor & Gamble (PG), IBM (IBM), and so forth. A select few companies like these also have a long history of not only paying regular dividends, but regularly increasing them as well. Long time investors call these stocks dividend aristocrats.
Tech and biotech companies, on the other hand, are newer, presumably higher growth, and are most likely to invest any profits (if indeed they even have profits) back into products or technology. Typically, such stocks are more “volatile” (jump up and down a lot more every day than those old-line companies we just mentioned). You typically invest in them hoping for potentially greater growth and higher capital gains, not dividends or income.
I won’t mention any names in this category just now. Just know that these stocks can be pretty speculative—something newer investors might not want to mess with just yet. But we’ll eventually explore them as well
Next: Preferred stocks
—Headline image: Institutional trader in action. (Public domain image via Wikipedia entry on investing)