Some pressing questions are common among investors:
• What’s the best way to generate income during and after prime working years?
• What’s the best way to protect assets from the ravaging effects of inflation?
• What might be the most feasible way to get returns while minimizing risk?
To some, finding answers may seem like a daunting task. Where might an investor begin? The specifics will vary according to individual circumstances.
Fortunately, it doesn’t have to be quite as complicated as it sounds.
One of the most common goals of investing is capital appreciation. Capital appreciation investments include things like real estate, mutual funds, ETFs, municipal securities, and other assets that tend to (but not always) involve higher-than-average risk.
What is Capital Appreciation?
Capital appreciation is a way to grow money over time. The term refers to an increase in the price of an investment. The total appreciation of an asset equals the difference between the price at the time of purchase and the price at the time of sale.
Let’s say an investor purchases 100 shares of stock in imaginary Company A for $5 a share, for a total of $500. The imaginary company does well, and one year later the share price increases to $10 a share.
Those same 100 shares would now be worth $1,000. The capital appreciation is calculated by subtracting the original amount of capital invested from the total amount the investment is now worth.
In this example, the equation would look like this:
$1,000 – $500 = $500
The capital appreciation would be $500, which is sometimes also expressed as a percentage. In this imagined example, the appreciation would be 100% because the price doubled, or increased by 100% of its original value.
Of course, things don’t always work out so nicely. All investments carry risk.
Risks Associated With This Type of Investment
Assets intended for capital appreciation tend to come with greater risk than those intended for capital preservation.
For example, government-backed Treasury bonds are considered to be among the lowest-risk assets on the market. But bonds are for capital preservation and income (the interest paid to the bondholder), not for capital appreciation. Dividend-yielding stocks are similar to bonds in that they earn income and carry less risk than capital appreciation assets.
Equities that do not yield dividends only become profitable when their prices appreciate, and therefore are considered to carry more risk. Investing in equities for the capital appreciation alone is also known as growth investing. The term has its roots in the fact that a small company with a low share price needs to grow to return higher value to its shareholders.
Smaller companies tend to be risky because they have had less time to prove themselves and have a greater chance of going bankrupt than larger companies. That’s why penny stocks (stocks that trade under $5) are considered to be among the riskiest equities available.
But individual stocks are not the only assets intended for capital appreciation.
Assets Designed for Capital Appreciation
There are a few main categories of assets designed for profit through appreciation. These are things that investors typically hold for the long-term in the hopes that prices will rise. While this isn’t an exhaustive list, it provides a good overview.
Real estate is a piece of land and anything attached to that land. Residential real estate is only one example. There is also real estate related to commercial, industrial, and agricultural activities.
Real estate investment trusts (REITs) are securities tied to companies that own real estate or operate related assets. REITs trade like stocks and give investors exposure to real estate without having to own physical property. REITs pay dividends but are often considered to be higher-risk than dividend-yielding stocks.
A mutual fund consists of a pool of money from many investors. The fund might invest in any variety of assets including stocks, bonds, short-term Treasury notes, or anything else.
Exchange-traded funds (ETFs) are investment vehicles that contain a group of different stocks, bonds, or commodities. ETFs can track stocks in one particular industry, e.g., gold mining stocks, or they can track all the stocks in an entire index such as the S&P 500.
ETFs are referred to as passive investing because they don’t require any management on the part of the investor—investors simply buy the ETF as they would an ordinary stock and continue to hold it.
Stocks are a type of security that represent ownership in a corporation. They can be thought of as little pieces of a publicly traded company that can be purchased on an exchange.
For long-term capital appreciation, the stocks of large companies tend to be sought after. As mentioned earlier, penny stocks tend to be seen as highly risky and speculative.
Some examples of commodities include oil; copper; agricultural commodities like corn, wheat, and soy; and precious metals like gold, silver, and platinum. Commodities have what’s known as “intrinsic value,” meaning they have value in and of themselves. Whereas stocks, bonds, or other securities have their value tied to something else like the profits of a company, commodities are desirable for their different use cases (e.g., oil is needed to fuel vehicles).
Precious metals, in particular, may be used by some investors as long-term stores of value and sometimes see significant capital appreciation in times of crisis. Gold and silver have many industrial uses, particularly in making electronics like computers, smartphones, tablets, and TVs. Measured against the value of national government-issued fiat currencies (like the US dollar, also known as the Federal Reserve Note), gold and silver have appreciated well over time.
What Causes Capital Appreciation?
There are a number of things that can lead to capital appreciation of a given asset. These include factors specific to an individual investment as well as those affecting the financial world as a whole.
In the most traditional and straightforward sense, a stock price rises because the fundamental value of the company it represents rises.
Central Bank Policy
Ultra-low interest rates, including zero-interest rate policy (ZIRP) can also play a role in rising asset prices. Some countries in the European Union and elsewhere have even instituted negative-interest rate policy (NIRP).
How do interest rates influence asset prices?
A lower interest rate gives corporations the ability to borrow money at a lower cost. They can then use the borrowed money to invest in and grow their business, or they can buy shares of their own stock, known as corporate share buybacks. In this way, lowering interest rates allows central banks to flood the economy with money without having to create new currency.
Quantitative easing (QE), on the other hand, refers to a method of central bank intervention in which central banks purchase long-term securities to increase the supply of money and encourage investment and lending.
These methods can lead to asset prices rising because more money is being added to the economy—money that then flows into assets, bidding their prices higher.
A strong economy overall can also contribute to certain assets rising in value. When economic growth is positive across the board and most companies are doing well, people typically have good jobs and can afford to spend more money. This can cause the price of assets to rise, as people are more willing and able to pay higher prices for things.
The opposite of this scenario is also true. When the economy as a whole endures a downturn, asset prices can fall. A good example of this would be the housing crash and resulting recession of 2008.
Another potential cause of appreciation is speculation. Rather, speculation can lead to the illusion of legitimate appreciation.
Speculation occurs when many investors perceive the value of a particular asset as being higher than it really is and start buying the asset in anticipation of a higher price. This leads to the price being bid higher, but eventually it drops sharply as investors sell in a panic when they realize there’s no fundamental reason to keep holding the asset.
Capital Appreciation Bonds
Capital appreciation bonds are sometimes referred to as municipal securities because they are backed by local governments. They’re also sometimes referred to as zero coupon bonds because they don’t pay out interest until their maturity date. With these bonds, investors hope to receive a large return in the future by investing a small amount upfront.
Like all bonds, municipal securities yield interest. But instead of paying out interest annually, the interest gets compounded regularly until maturity. This leads to greater appreciation and gives the investor one lump sum payout at the end of the bond’s lifetime.
There are a few terms investors should be familiar with when it comes to capital appreciation bonds.
• The initial amount of money invested into a bond is known as the principal. On the maturity date, the company issuing the bond must pay back the principal plus accumulated interest.
• Par value refers to the amount investors receive when holding a municipal security until maturity. The difference between the principal and the par value is the amount of profit an investor will make, which is also referred to as the return on investment (ROI).
• The interest on a bond is the money paid to bondholders in exchange for investing. With most other bond types, interest is paid out on an annual basis. With capital appreciation bonds, however, no interest payments are made until maturity. This is beneficial to both investors and bond issuers. Companies that issue these bonds don’t have to make interest payments until later, when their company may be earning greater profits. And investors receive a greater return due to compounding interest.
• Time frame is the amount of time investors must wait before the bond reaches maturity. It can be possible to cash out of a bond early, but there will often be penalties associated with doing so. Capital appreciation bonds tend to offer longer terms than other municipal or corporate bonds. Ten years or 20 years are common time frames. This makes these bonds well-suited for long-term financial goals.
Capital Appreciation vs. Capital Gains
It should be noted that there is a difference between gains in terms of the price of an asset and the profits or losses realized from selling that asset. Profits and losses are not considered to be “realized” until a sale is made, at which point the capital gain or loss has been made real.
That’s an important point to keep in mind when witnessing the value of an investment going down, as will happen from time to time. Price declines don’t always spell losses, as losses are only realized at the time of sale.
Let’s go back to our previous example.
An equity investment worth $500 that becomes worth $1,000 saw capital appreciation of $500. If our imaginary investor were to sell at that position, the $500 appreciation would become a capital gain, subject to capital gains tax.
Capital gains tax can get complicated. The amount owed on capital gains varies according to three main factors:
• If the capital gain or loss was short term (less than 12 months) or long term (more than 12 months).
• The type of asset bought and sold.
• Which tax bracket an investor falls into, which is mostly determined by annual income.
Long-term capital gains tax rates are lower than those on short-term capital gains—just another reason why some investors might choose to hold investments for the long-term.
Capital appreciation is one part of a long-term investing strategy. Without it, building wealth over time might be much more difficult. SoFi can help investors get started managing their assets and making sure they grow well into the future. The no-cost financial planning offered to SoFi members can help build a budget, reach investment goals, borrow the right way, and more.
The information provided is not meant to provide investment or financial advice. Investment decisions should be based on an individual’s specific financial needs, goals and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA / SIPC . The umbrella term “SoFi Invest” refers to the three investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.
Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.
External Websites: The information and analysis provided through hyperlinks to third party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.