The Difference Between Capital Gains and DividendsWhile making money is making money, there is a big difference between capital gains and dividends. Capital gains come from making a profit when you buy and sell an investment while dividends usually come from a company paying their earnings out to shareholders.
How to Get Capital GainsMost investors get capital gains from simply buying an investment and selling it at a higher price. A capital gain can also be made from selling short and then buying an investment to cover that short position. This short strategy is used by funds, wealth managers and advanced investors so in this post I’ll only address the more common method of buying an asset and subsequently selling it for less than the cost. (My goal at Retire Certain is to be thorough without fire hosing readers with TMI (too much information).)
Investing Goals Determine if Dividends or Capital Gains Are BetterThere is really no one answer to whether dividends or capital gains are better. Both are good since they increase wealth, but there are some advantages of one over the other at certain times. Your own investing goals as outlined in your personal wealth plan will guide you to whether dividends or capital gains are better for you at any given time. It’s easy to get lost in the allure of making a certain dividend or capital gain from an investment without investing based on your overall wealth plan. A wealth plan with investing goals, however, is the starting point for determining whether capital gains or dividends will help you achieve financial independence. Click here to read my post How to Create a Wealth Plan.
Value Investing as a Primary GoalAs you have probably read here, I am also a big believer in buying undervalued assets as a main investment strategy regardless of dividend or capital gain goals, which I address more near the end of this post. This means I may put the goal of dividend income or a capital gains pursuit on the back burner when the investments to accomplish either can’t be found at prices lower than historical norms. This is what more tactical investors do, and many wealth managers use this approach for their high net worth clients. Legendary stock investor Warren Buffett took this same position, for example, in early August of 2019 when his second quarter operating results revealed a record $122.4 billion accumulated in cash and cash equivalents. Buffett has previously said he prefers keeping around $30 billion in cash. While Buffett didn’t say so outright, the high cash position suggests that he thinks stock markets are overvalued based on his strategy of buying undervalued assets. (And if Buffett did outright say that stocks are overvalued it could trigger a huge selloff in the stock market given the influence he has on investors.) Having made it clear it’s important to consider valuation before buying any investment, whether for dividends or capital gains, especially later in life, let’s delve into dividends vs. capital gains more so you can decide which is better for you.
Dividends Are for Living Off InvestmentsDividends are associated with living off investments. Companies that pay dividends are usually older, more established companies. This is because younger, faster growing companies need to invest their profits back into their own company to expand and continue growing. To clarify this point, here’s an example of an investor who decided dividends would be better than capital gains as a primary investment goal. A 60 year old recently retired investor named Jim is ready to live off investments in dividend paying stocks. From his overall wealth plan, he sees that his stocks generate enough income to live how he wants so he doesn’t have capital gains (wealth building) as his main investing goal. As a general rule, when you have enough money to live off investments, and you’re doing it, capital gains take a back burner to dividends. This is because once you have decided to live off investments you will structure assets to get income from them. For stock investors, this income is from dividend income. This is an important point in deciding if dividends or capital gains are better for you. My related post When to Switch from Growth to Income explains this more. This is the case with Jim. Therefore, he has decided that dividends are better than capital gains based on his investing needs. My post Is Dividend Investing Worth It? has an excellent dividend chart.
Jim’s Dividend Income on $1,000,000For example, Jim buys dividend stocks of $1, 000,000 that pay dividends of 4% on average. He will collect $40,000 a year, or $3,333 a month from his dividend stocks. In this example, you can see that dividends are a better choice for Jim since he is living off investments and his investments already are enough to continue to do so. This is assuming Jim is happy with his net worth, and he feels it will provide funds for life. My related post How to Get More Income from Your Investments has 43 income strategies besides dividends. My post How Much Money Do I Need to Invest to Make $10000 a Month compares income investing strategies.
Capital Gains Are for Wealth BuildingAnother investor, Jan, is 50. She makes $250,000 a year from her employment. This covers her expenses and allows her to save some money every month. She has $ 500,000 in stock and bond investments. From her personal wealth plan, Jan knows she has not yet reached the level of invested net worth that she wants so she can live off investments comfortably in retirement. For this reason, capital gains are better than dividends for Jan’s investments. Read How Much Money Do You Need to Live Off Investments where I explain this more.
Wealth Building from Income Generating InvestmentsHaving explained when dividends are better than capital gains and vice versa based on traditional investing rules, here’s an important point that often gets muted with traditional, long term asset allocation investing: Income generating investments can also build wealth. They can do this in two primary ways.
1. Long Term InvestingOver time most quality assets increase in value. This means that investors can build wealth passively while also receiving dividend income from investments. Just keep in mind that the assets chosen for dividend investing are usually somewhat different from the investments bought for capital gains. As mentioned, growth investments are bought specifically for capital gains while more established companies are bought for dividends. My related post How to Build Wealth explains this more.
2. Mean ReversionQuality stocks that are bought below historical valuations usually return to their previously higher valuations. I feel I must be careful to explain that this is not always the case, but it usually is. Exceptions occur when there are major “disruptors”, such as the internet, major political changes, or complete mismanagement, such as Enron shenanigans or overextended lenders before the financial crisis. But most quality stock values naturally move over or under a historical average. This is known as “mean reversion” in financial lingo. My post How to Know if The Stock Market Will Go Up or Down explains this more. When investments are bought under the historical mean, investors experience capital gains as the value of that investment rises back up and over the mean. This method of buying quality assets at low valuations can create capital gains faster than when investors ignore valuations. This mean reversion happens with dividend stocks after bear markets. When it happens, investors have both dividends and capital gains. And having both capital gains and dividends is sort of like having your cake and eating it, too.
TaxesTaxes are treated differently for dividends vs capital gains. And capital gains that occur in less than a year are even treated differently from those that don’t. Not only do tax rules change often, they vary greatly from one investor to the next based on income, dependents and other factors. For this reason, you’ll want to ask your CPA about taxes for dividends vs capital gains.
So, Are Dividends Better Than Capital Gains?Making the choice to focus on dividends vs capital gains is a major factor in investing. When you start with an overall wealth plan, you’ll have more clarity about which is better for you based on your own investing goals. As you can see, there are times when dividends are better than capital gains for investors, and there are times when capital gains are better than dividends for investors. There is no one answer for everyone, as is always the case with investing your money.
The information on this website is for education only and is not to be construed as personal financial advice.