One of the most important goals for any smart investor is to thoroughly understand the nature of investment income. All of us invest our hard-earned money in order to profit from the investments and make more money, don’t we! In the world of investing, many thousands (and perhaps millions) of investment options are available to us. So, how do we judge which instrument (investment option) to invest in and which to reject?
We can give a good answer to this question only if we fully understand investment income. The purpose of all investment is to make profits. Thus, the key to identifying which investment option is better than others lies in identifying which investment option offers greater income. (Sometimes, it may also be important to understand the frequency and timing of incomes received from an investment.) So, let us quickly understand the nature of investment income.
Types of Investment Income
As we all know, the world of investments offers massive amount of choice – there are thousands and thousands of different income producing investment options available for investors. While each of these investment options would generate some income, the nature of the income may vary. Typically, investment income may be in the form of capital gains, rent, dividend or interest or a mix of some of these.
As the nature of incomes vary, different investments may be taxed differently. For example, in certain cases, long-term capital gains may be taxed at a lower rate than short-term capital gains. Similarly, income from some long-term bonds or from long-term deposit accounts may be taxed at low rates. Further, income from certain bonds issued by government bodies may be entirely tax-free. The tax rate applicable on an investment is an important factor in evaluating that investment option. This is because the amount (net income) that you would gain from an investment is the income after tax.
Let us now understand each of the different types of investment income.
Many different types of investments involve purchase of an asset. For example, investing in the shares of a company involves buying some shares of the firm. Investing in real estate may involve purchasing some property. In such cases, when you sell the asset, the net income received is called capital gains (or loss). Do note that net income is simply the difference between the price at which you sold the asset and the cost that you had incurred while purchasing the asset.
Suppose you purchase 100 shares of a company for $50 each. After 3 years, you sell off the shares for $60 each. In this case, your capital gains = selling price minus cost price = $60 X 100 – $50 X 100 = $6,000 – $5,000 = $1,000.
In this case, the $1,000 capital gains would be categorized as long-term capital gains since the investment was made for a period of 3 years. Generally, capital gains that are realized over a period of less than a year are categorized as short-term gains (though different regions – and different instruments – may follow different rules).
Investments in the real estate sector may often generate rental income. Suppose you purchase an apartment in a posh locality of a large town. You may intend to sell the flat after a period of 5 years and thereby benefit from capital gains on the flat. So, what do you do with the apartment during the 5 years? You may simply keep the flat locked up. Or, you may choose to stay in the flat yourself.
You may also choose to lease the flat to an individual or to a corporate entity. In this case, you retain ownership of the flat while the tenant gets the right to use the flat for some period of time. In lieu of this right, the tenant would pay you a fixed amount (often on a monthly basis). This regular amount – called rent – is an additional income (over and above the capital gains) that you derive from your investment.
Investment in shares of a company can often yield some dividend income along with capital gains. When you buy some shares of a company, you have essentially purchased a part of the company. A profitable company may often decide to distribute some or all of its profits among its owners (i.e. among its shareholders). The share in profit received by a particular shareholder is the dividend income of that shareholder.
Many well-established and profitable companies issue regular dividends to their shareholders. Such dividends may often be paid periodically (typically, on an annual basis). If you choose to invest in shares of such companies, you should make it a point to include likely dividend received along with potential capital gains while calculating your expected income from the investment.
When you borrow some money from a bank or some other financier, you are required to pay some interest on the money that you have borrowed. Similarly, if you lend money to someone, the borrower would pay some interest to you. When you deposit some money in a bank account, you are essentially lending money to the bank. Thus, the bank would pay some interest to you for the period for which you lend your money to the bank.
When you purchase a bond, you effectively lend some money to the issuer of the bond. This money is lent at a fixed rate of interest and for a predetermined period of time (generally). Accordingly, the issuer of the bond would pay some interest to you for the period for which you have lent your money. When the bond matures, the issuer of the bond would return the money that you had originally lent.
Types of Investments and Nature of Income
You have already understood the common types of investment income. Let us now quickly take a look at some of the most common (most popular) categories of investments and the types of income that they typically offer.
The equity market is a very common (and popular) investment avenue. As we have seen above, shares of different companies can typically provide capital gains as well as dividend income.
Investing in a bond can yield interest income as well as capital gains. A bond issuer is required to pay interest on the amount that you lend to them. Further, some bonds can be sold before maturity in designated markets. Selling a bond can lead to capital gains as well.
Investments in the real estate sector typically aim to benefit from capital appreciation. Further, such investments can also lead to rental income.
Investing in a bank account or a corporate deposit is equivalent to lending money to the bank or to the corporate entity in question. Thus, such deposits lead to interest income.
Professionally Managed Funds
Instead of investing in assets (such as real estate, stock, bonds, etc.) directly, investors may allocate their funds to various funds. Some such funds may invest only in shares or only in bonds while other funds may invest in a mix of shares, bonds, and other instruments. There are even some funds (called fund of funds) that invest in a group of funds. As funds may invest their portfolio across many different types of investments, they may generate many different types of income. Capital gains and dividend income are the two most common types of income that various funds offer to investors.
This is all that you need to know about investment income. You are now fully empowered to judge how exactly any investment opportunity would offer returns (income) and profits. You would now be able to correctly judge the net worth of any investment opportunity. Thus, you would now be able to make intelligent and smart investment decisions.
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