The term capital appreciation refers to an investment’s value rising over time. Theoretically, capital, meaning money or funds, appreciates, or goes up (as opposed to depreciates) after an investor initially purchases it, and that rise in value is what’s referred to as capital appreciation.
Of course, capital can also depreciate, but investors aren’t usually looking for negative returns. This is an important concept for investors to grasp, too, as capital appreciation is likely the main goal of most investors’ overall strategies.
What Is Capital Appreciation?
As noted, capital appreciation refers to a rise in the price of an investment. Essentially, it is how much the value of an asset has increased since an investor purchased it. Analysts calculate capital appreciation by comparing the asset’s current market price and the original purchase price, also called the cost basis.
Example of Capital Appreciation
Capital appreciation can be understood by analyzing an example from stock market investing.
If an investor purchases 100 shares of Company A for $10 a share, they are buying $1,000 worth of stock. If the price of this investment increases to $12 per share, the initial 100 share investment is now worth $1,200. In this example, the capital appreciation would be $200, or a 20% increase above the initial investment.
💡 Quick Tip: Look for an online brokerage with low trading commissions as well as no account minimum. Higher fees can cut into investment returns over time.
What Causes Capital Appreciation?
The value of assets can rise and fall for various reasons. These include factors specific to individual investments and those affecting the economy and financial world as a whole.
In the most traditional sense, the price of an asset will increase because of a rise in the fundamental value of the underlying investment. When investors see that a company is doing well and expect it to keep doing well, they will invest in the company’s stock. This activity pushes the stock price up, resulting in capital appreciation if an investor holds shares in the company.
For a real estate asset, the value of a property could go up after a homeowner or landlord renovates a structure. This capital improvement increases the property’s market value.
When the economy is booming, it can buoy all kinds of financial assets. In a strong economy, people typically have good jobs and can afford to spend money. This helps many companies’ bottom lines, which causes investors to put money into shares of the company. The opposite of this scenario is also true. When the economy endures a downturn, asset prices may fall.
Recommended: Understanding Economic Indicators
Central banks like the Federal Reserve play a significant role in how the financial markets operate. Because of this, the monetary policy set by central banks can play a prominent role in capital appreciation.
For example, when a central bank cuts interest rates, corporations can usually borrow money at a lower cost. Businesses often use this injection of cheap money to invest in and grow their business, which may cause investors to pour into the stock market and push share prices higher. Additionally, companies may take advantage of lower interest loans to borrow money to buy shares of their stock, known as a stock buyback. These moves may push share prices higher, further leading to capital appreciation.
Another monetary policy tool is quantitative easing (QE), which refers to a method of central bank intervention where central banks purchase long-term securities to increase the supply of money and encourage investment and lending. Like a low interest rate policy, this method can lead to rising asset prices because more money is being added to the economy — money that flows into assets, bidding their prices higher.
Another potential cause of capital appreciation is speculation. Speculation occurs when many investors perceive the value of a particular asset as being higher than it is and start buying the asset in anticipation of a higher price. This activity may lead to the price of an asset being pushed higher. After a frenzy, the price of the asset eventually drops as investors sell in a panic when they realize there’s no fundamental reason to keep holding the asset. This type of speculation is fueled by investors’ emotions, rather than financial fundamentals.
Assets Designed for Capital Appreciation
There are several categories of assets that are designed for returns through price appreciation. Investors generally hold these investments for the long term hoping that prices will rise. This isn’t an exhaustive list, but it provides a good overview.
Stocks are a type of financial security that represents equity ownership in a corporation. They can be thought of as little pieces of a publicly-traded company that investors can purchase on an exchange, with hopes that the price of the shares will go up.
Real estate is a piece of land and anything attached to that land. Many people build wealth through homeownership and capital appreciation, buying a house at a specific price with an expectation that it will appreciate in value by the time they are ready to sell.
Residential real estate is just one area of real estate investment. Investors may also look to put money into commercial, industrial, and agricultural real estate activities. Investors can invest in various real estate investment trusts (REITs) to get exposure to returns on real estate.
A mutual fund consists of a pool of money from many investors. The fund might invest in various assets, including stocks, bonds, commodities, or anything else. In the context of a mutual fund, capital appreciation occurs when the value of the assets in the fund rises.
Similar to mutual funds, 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 track all the stocks in an entire index such as the S&P 500. As the name suggests, ETFs are bought and sold on exchanges just like stocks.
Commodities are an investment that has a tangible economic value. This means that the market values these raw materials because of their different use cases. For example, commodities like oil and wheat are desired because they can power automobiles and be used for food, respectively. Commodities markets can be highly volatile, but many investors take advantage of the volatility to see the capital appreciation on both a short-term and long-term time horizon.
💡 Quick Tip: Distributing your money across a range of assets — also known as diversification — can be beneficial for long-term investors. When you put your eggs in many baskets, it may be beneficial if a single asset class goes down.
Capital Appreciation Bonds
Capital appreciation bonds are municipal securities backed by local government agencies. With these bonds, investors hope to receive a significant return in the future by investing a small amount upfront.
Like all bonds, capital appreciation bonds yield interest, which is a primary reason that investors buy them. But instead of paying out interest annually, the interest gets compounded regularly until maturity. This gives the investor one lump sum payout at the end of the bond’s lifetime.
Unlike other assets that experience capital appreciation, the price of the capital appreciation bond does not rise. Instead, capital appreciation refers to the compounded interest paid out to the bondholder at maturity.
Capital Appreciation vs Capital Gains
Though the terms are sometimes used interchangeably, there is a difference between capital appreciation and capital gains.
Capital appreciation occurs when the value of an investment rises above the purchase price while the investor owns the asset. In contrast, capital gains are the profit made once an investment is sold. Appreciation is, in effect, an “unrealized” gain. It becomes “realized” once the investment is sold for a profit.
Capital appreciation alone does not have tax implications; an investor doesn’t have to pay taxes on the price growth of an investment when they own it. But when an investor sells an investment and realizes a profit, they must pay capital gains taxes on the windfall.
Capital Appreciation vs Income
Capital appreciation is one piece of the puzzle in an investment strategy. Another critical component to build wealth is investing in assets that pay out dividends, interest, and other income sources.
A dividend is a portion of a company’s earnings paid out to the shareholders. For every share of stock an investor owns, they get paid a portion of the company’s profits.
Interest income is typically earned by investing in bonds, otherwise known as fixed-income investments. The interest payment is determined by the bond’s yield or interest rate. Investors can also be paid interest by putting money into savings accounts or certificates of deposit (CDs).
For real estate investors, rents paid by tenants can also act as a regular income payout.
Investing in assets that pay out regular income can supplement capital appreciation. The combination of capital appreciation with income returns is the total return of an investment.
Risks Associated With This Type of Investment
Assets intended for capital appreciation tend to be riskier than those intended for capital preservation, like many types of bonds.
Investing in stocks for capital appreciation alone is also known as growth investing. This strategy is typically focused on investing in young or small companies that are expected to increase at an above-average rate compared to the overall market.
The returns with a growth investing strategy can be high, but the risk involved is also high. Because they don’t have a long track record, these small and young companies can struggle to grow their business and lead to bankruptcy.
Capital appreciation refers to the rise in value, or price, of an investment in an investor’s portfolio. It’s paramount to the whole concept of investing, as most investors invest in an effort to generate returns, or appreciation, on their money.
Capital appreciation is one part of a long-term wealth-building strategy. Along with income from dividends, interest, and rent, capital appreciation is part of the total return of an investment that investors need to consider.
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What is the difference between capital growth and capital appreciation?
The difference between the terms capital growth and capital appreciation is merely semantics. Both terms refer to an increase in value of an investment over time, and effectively mean the same thing.
How much tax do you pay on capital appreciation?
Investors do not pay taxes on capital appreciation, as an investment gaining value does not trigger a taxable event. They do pay taxes on capital gains, which are realized when an investor sells an asset.
What is the difference between dividend and capital appreciation?
A dividend is a payout to shareholders from a company’s profits. Capital appreciation is the rise in market value of an investment or asset, so they are two completely different things.
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