There are two major reasons you invest; for cash flow or for capital gains. What’s the difference between cash flow and capital gains investing? Cash flow investing buys assets that generate income while capital gains investing buys assets with the expectation they will increase in value.
There are some important nuances with both cash flow investing and capital gains investing.. For example, the term “cash flow investing” is often loosely used for investing in income generating assets. And many investments can have both cash flow and capital gains as you’ll see.
This article will address these important factors and more. I also made a chart outlining the differences between cash flow and capital gains investing which is below so keep reading.
Major Investing Focus
One of the primary differences between cash flow and capital gains investing is the reason you do each.
What Is Meant By Capital Gains?
A capital gain occurs when an asset increases in price above the purchase price. If the asset is sold, the capital gain is realized. If the asset is held, the capital gain is considered unrealized.
What Is Meant By Cash Flow Investing
Cash flow investing refers to investing in assets that generate cash, or income. Retirees and those wishing to live off investments prefer cash flow investing over younger investors seeking to build wealth.
Cash flow is officially an accounting term that applies to how cash flows within business accounts. In recent years, however, the term cash flow investing has grown popular referring to investing in income generating assets.
The Difference Between Cash Flow and Income Investing
The main reason for cash flow investing is to provide funds to cover expenses, or even increase wealth if earnings are put into investments vs using it for expenses. On the other hand, the main reason for capital gains investing is to buy assets that increase in price during ownership so they can eventually be sold for a profit.
Timing for Cash Flow Vs Capital Gains Investing
Another major difference between cash flow and capital gains investing is in how long it takes to accomplish the desired result.
The goal from cash flow investing is accomplished when the expected income flows into your account. Cash flow investing is also referred to as income investing. . This usually occurs ongoing monthly or quarterly.
Real estate rentals and bond interest income may flow in monthly, for example.
Income can sometimes be received immediately after an income generating asset is purchased. For example, dividend income may be received within a day of buying a stock.
On the other hand, accomplishing the goal from capital gains investing often takes years. While there are exceptions, such as flipping real estate or short term stock trading, most investors have a very long term approach for achieving capital gains.
Exceptions to this are trading strategies, such as day trading or swing trading. Another exception is investing using more a tactical approach. For example, momentum based ETF rotation portfolios may experience capital gains over a few years.
Capital Gains Vs Income Investing and Taxes
Taxation is treated differently among the various aspects of both cash flow and capital gains investing but the two investing methods can also overlap when it comes to taxes.
Taxes are an important but often overlooked factor for investors to consider when choosing between cash flow and capital gains investing. There are many variables that affect how taxes will affect your investing results from either method so let’s look at this more.
Tax Favored Accounts
Investments made for cash flow are usually owned in a different type of account than capital gains investments. For example, capital gains tend to be held more often within a tax deferred account or a tax free account, such as an IRA or 401K. (Rules vary.)
On the other hand, income producing assets are often held outside a tax advantaged account. This is because, otherwise, the income would be “trapped” inside the tax deferred (or tax free) account. When this happens, the income cannot flow out to the investor unless a deliberate withdrawal is being made from the account, such as an RMD (Required Minimum Distribution). This is, of course, assuming the investor wants to make withdrawals and use the income generated from the investment to live.
Cash Flow Investments with Tax Benefits
Also, cash flow strategies can have benefits that lower overall taxes from investments based on the strategy itself, as opposed to just where the asset is held. For example, real estate rental ownership has the benefits of depreciation write-offs and 1031 exchanges that investors may use.
Another tax benefit example is when cash flow investments have tax benefits as a result of being structured as an S Corporation, which is common with small business.
Capital Gains Taxes
Then there are also the tax benefits from lower rates that apply to long term capital gains. This benefit, however, can apply to both cash flow investments, such as real estate, and capital gains investments, such as growth stocks, when these assets are sold for gains; they just happen to be income generating assets that produce cash flow for the investor.
You can see how much a role taxes play in both cash flow and capital gains investing.
Bull and Bear Markets
Since the primary goal of income investing is getting paid income, goal achievement from cash flow investing is usually less affected by economic and market cycles. While the value of the asset that generates the income often drops as a result of a bear market or economic slowdown, if the income continues to be paid, the goal is accomplished as long as the income keeps flowing in from the investment.
For example, a stock paying a reliable 5% dividend will likely continue to do so even if the value of the stock drops from $100 to $60 during the occasional bear market.
On the other hand, capital gains investing is very tied to economic and market cycles since accomplishing the desired result is dependent on the asset increasing in value.
In other words, if an investor buys a stock for $100 and it drops to $60, the goal has not been accomplished if the investor sells the stock. Of course, the investor can continue to own the stock. If it recovers and exceeds the investor’s cost, a capital gain may be incurred. The time frame for this, however, is very unpredictable.
Acceptance of Cash Flow Vs Capital Gains Investing
The most promoted method of investing among financial firms and the media is to buy stocks for long term capital gains. This is the easiest way to invest and it can work very well over long time frames.
Long term passive investing is what most financial advisors do. It’s promoted both in the media and by icons such as Dave Ramsey, and even Warren Buffett, although neither of them got wealthy from passive capital gains investing.
Cash flow investing is considered more alternative. Many cash flow investing methods take more effort than simply buying an asset with the hope that it will increase in value. In general, investors like to go with what is most common and easiest for logical reasons.
And many investors are just not aware of cash flow investing because of the overwhelming influence of mainstream investing. This trend, however, seems to finally be changing with the FIRE (Financial Independence Retire Early) movement among the younger generations and their affinity for alternative income generating assets that older investors aren’t as comfortable with.
Age Difference for Cash Flow Vs Capital Gains
Based on traditional investing methods, however, most young people focus on capital gains investing while they are employed. This is because they usually already make enough money to cover their living expenses from their jobs.
On the other hand, cash flow investing can be the best choice for income in retirement. . The newer trend, however, is toward early retirement from investments that generate cash flow for many younger, proactive investors.
In my video below, I talk more about retirement income with cash flow investing.
One last difference between cash flow and capital gains investing is how predictable successful results are.
Cash Flow Predictability
With cash flow investing, a successful outcome is more predictable for many investments than capital gains are. This is because it is easier to see the likely income from an investment than it is to predict whether an asset will increase in value while you own it.
For example, you can see how much dividend a company pays, or how much rental income property will generate. This is true from among the many types of cash flow investments. Income can change, of course, but it can be estimated with a more reliable and acceptable degree of accuracy than capital gains can. You know within a high level of certainty that when you buy a stock reliably yielding 6% those dividends will be deposited into your account, unless, of course, the dividend gets cut, which occasionally happens.
Capital Gains Predictability
On the other hand, the value of a non dividend paying growth stock or index fund could drop and you don’t get the intended capital gain.
Of course, having an awareness of and investing around economic and market cycles increases the predictability of capital gains. It is for this reason I address the importance of having an awareness of such cycles in my work.
Are Capital Gains Considered Cash Flow?
Many investors now consider regular and recurring capital gains as cash flow investing. Theoretically, if profits are being consistently generated, they can be used for income purposes. For tax purposes, however, capital gains have different treatment than income generated from cash flow investments.
Maybe it’s the old accountant in me, but I differentiate capital gains from cash flow as a primary investing goal. Capital gains are one thing and cash flow is another.
Should I Invest for Cash Flow?
As a financial coach, clients often ask if they should invest for cash flow.
Investment selection should stem from an overall wealth plan that defines whether income or capital gains is the primary goal at any given time. If the main investing goal is income generation at a given life phase, then cash flow investments usually make the most sense. If an investor is in the accumulation, or wealth building phase, investing for capital gains as a primary goal makes the most sense.
Of course, here are Retire Certain a core tenant is revamping the entire plan of ending the wealth building phase in retirement.
While there are major differences in cash flow and capital gains investing, they don’t have to be mutually exclusive. When investors buy cash flow assets that also generate capital gains over time, they can both pay the bills and build wealth from the same assets. Now that’s what I call a double wealth builder.
Learn about my triple and quadruple wealth builders in my Ultimate Wealth Plan. You can get it here now.