1) Investing for Tax Reduction
2) Investing for Capital Appreciation
3) Investing for Income
Let’s take a look at these three approaches individually:
INVESTING FOR TAX REDUCTION
With this approach, you’re investing to reduce your tax exposure. Taxes are right up there with housing and the cost of raising kids as one of life’s biggest expenses. When you’re investing for tax reduction, you’re looking for ways to either reduce your tax burden, or increase the amount of tax-favored income that you receive.
For example, investors that are seeking a more tax-favored status for their money may move some capital into a vehicle such as municipal bonds. Investing in a municipal bond provides interest income that is free of federal taxes, and in some cases, the income can be free of state and local taxes as well.
INVESTING FOR CAPITAL APPRECIATION (AKA CAPITAL GAINS)
You’re investing for capital appreciation because you want a bigger pile of money than you had before. The philosophy here is that you buy an asset for a certain price with the intention of selling it for more. For example, if you buy an asset for $10 and sell it for $15, that $5 increase represents your profit in the form of a capital gain – the appreciation in the perceived value of the asset. When most people think of investing, this is the approach that they normally have in mind.
You see this in the real world when someone buys a house for $250,000 and then sells it for $275,000 a month later. They “flipped” the property for a quick profit in order to realize a short-term capital gain. While I’m not the biggest fan of investing for capital gains (it’s often speculative and labor-intensive), it can definitely have its place in a well-rounded financial plan.
INVESTING FOR INCOME
With this approach, you’re investing because you want a stream of cash flow from your investments. Referencing the example above, you’d buy that same asset for $10 not because you want to try to sell it for $15, you’d buy it because it pays you $0.75 every year as long as you hold the asset in your portfolio. That $0.75 in annual cash flow represents your investment income.
A prime example of this is when an investor buys stock in a company that pays dividends. While there’s the potential for the price of the stock to go up (investing for capital appreciation), the investor is eligible to receive cash dividends while they hold the stock in their portfolio (investing for income).
These are the general approaches we can take as investors. Yes, there are various investment vehicles and strategies available in the financial marketplace. But when you really break it down, you’re investing using one or some combination of the three fundamental approaches: you’re investing for tax reduction, you’re investing for capital appreciation, or you’re investing for income.
Personally, my preference is investing for income. I’ll detail some of the major advantages of income investing in a future blog post. For now, just know that it works extremely well in conjunction with the other two approaches: you can profit via capital appreciation while investing for income, and you can also reduce your tax exposure while investing for income.
Those are my thoughts. Feel free to share some of yours below. Thanks for reading and as always, make it a great day.