What Are Capital Gains

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By buying into stocks that are trading for less than their fair value, you're essentially betting on their eventual rise. You can execute this strategy on a daily, weekly, monthly, yearly, or even a longer basis. Personally, I prefer multi-year, long-term horizons.

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Why? Because planting seeds is one thing, but real flowers need time to bloom. And the due diligence, thorough research, and associated patience is often rewarded in the long-term. But, it's not without its risks—you've got to be able to tell the difference between a hidden gem and a dud.

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Here is an example of how capital gains work. Picture this: back in 2019, you decide to invest in Apple. You snagged some shares at $50 each, thinking it was a pretty good deal.

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Fast forward to April 2024, and those same shares are now sitting pretty at $169 apiece. Now, you've got a choice to make.

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          Option one: you could cash in now, taking those sweet capital gains and pocketing the profit of $119 per share.

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          Option two: you could hold onto those shares, betting on Apple's continued success and the potential for even higher gains down the road.

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                                                              "Our favorite holding period is forever." -Warren Buffett

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As long as the fundamentals of a company's operations remain strong, preferably with an enduring competitive advantage within it's core industry, it's advantageous to remain vested. True, there is some risk and price volatility (even in good markets), but that's the price you pay for all the upside potential.

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Keeping your emotions in check is critical as long as you still have long-term confidence in an investment. Weathering the ups & downs of price volatility and negatively perceived short-term events will allow excellent long-term benefits to remain in place.

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Stay vested or cash out? Which option you take is entirely up to you. Now, let’s talk about the second strategy.

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What Are Dividends

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Dividends are basically rewards that companies give to their shareholders for holding onto their stocks, usually in the form of cash on a quarterly basis (annually in the EU).

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As detailed in this article by Forbes, the qualities of the best dividend stocks overlap with the qualities of strong value stocks. These include a proven business model, ample cash flow and leadership team that's dedicated to rewarding its shareholders.

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But in large part, for a dividend focused investment strategy to work, you need companies that can keep churning out those dividends year after year. Like Warren Buffett says, "look for companies with enduring competitive advantages."

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Even better if these companies are increasing their dividends. Why? Because there's a clever, complementary strategy called dividend reinvesting. Let me explain how it works.

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Dividend reinvesting is when you use the dividends paid by a company to buy more shares of that same company's stock instead of taking the cash. It's effectively compounding interest on your investment because you're continually buying more shares, which creates more investment capital working for you in the form of both capital gains and additional shares. This can lead to accelerated growth and higher ROI (total return on investment) over time.

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Plus, dividend reinvestment can be automated by almost all brokers these days. Now that you have a clear picture of the two strategies, it’s time to choose.

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Capital Gains Or Dividends?

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Individual investors can use various investment strategies to reach their investment goals. But in general, when it comes to focusing on capital gains versus dividends, the right answer is capital gains. And there are good reasons behind that.

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Firstly, capital gains are more tax-efficient. While you're required to pay taxes on dividends annually, taxes on capital gains are incurred only if and when you sell. Therefore, pursuing long-term strategies may help minimize the tax impact.

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Secondly, the potential for growth is greater when the primary focus is on capital gains. Not all companies pay dividends, and those that do are often mature companies with limited expansion plans. If you're still young and seeking higher returns, focusing on capital gains can offer more lucrative opportunities.

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Dividend payouts are also going to only be a small fraction of the total value of investment shares. For example, Coca-Cola ($KO) is now a well-established company with limited growth opportunities. As such, KO stock has limited upside in the appreciation of the stock's value, but the company has a strong free cash flow and is well known for providing returns to shareholders in the form of dividends.

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Currently, one share of KO is on the market for $60.34. And each share is accompanied by an annual dividend of $1.94 (a relatively high dividend payout ratio compared to other companies). So, depending on how much dividend income you're looking to attain, you'd need to own hundreds of shares of KO to establish any meaningful dividend income. At current levels, for instance, an annual payout of $50K in dividends would require ownership of more than 25 thousand shares of Coca-Cola, which would equate to ownership of +$1.5M worth of shares.

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Dividends are a nice "bonus" to have with respect to stock investments, but the focus should primarily be on capital appreciation. It's good to have both in place, but a focus on capital appreciation with equity investments is recommended.

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Conclusion

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That said, if your primary aim is to generate steady cash flow, reliable dividend stocks can meet your needs. However, at RIIQ, we're on the lookout for more promising opportunities.

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Remember that investing is not an exact science, and this especially holds true as you're scouring the market for small groups of excellent companies that may be selling below their intrinsic values. Be sure to include a few recommended tactics in your investment strategy:

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1.    Invest in companies with a margin of safety - read more in our write-up on the same topic here Margin of Safety

2.   Diversify your portfolio without overdiversifying - read more in Optimal Diversification

3.   Have patience and focus on the long-term

4.   Avoid emotional decisions

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Keep reading my articles and keep watching my socials. And, to get my best work, feel free to join the world’s most powerful stock market newsletter for wealth, stability, and happiness.

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Disclosure/Disclaimer

As a Tykr affiliate, Raising InvestorIQ earns from qualifying purchases. As a Seeking Alpha affiliate, Raising InvestorIQ earns from qualifying purchases.

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Information provided on this site is based on my own personal experience, research, and analysis, and it is not to be construed as professional advice. Please conduct your own research before making any investment decisions.  I am not a professional financial advisor, stockbroker, or planner, nor am I a CPA or a CFP. The contents of this site and the resources provided are for informational and entertainment purposes only and do not constitute financial, accounting, or legal advice. The author is not liable for any losses or damages related to actions or failure to act related to the content on this website.

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