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Cash Flow vs Capital Gains: Understanding the 2 Types of Investment Income

Financial freedom is about how you invest; understanding these 2 types of investment income will get you there.

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Financial freedom is about how you invest; understanding these 2 types of investment income will get you there.

Kim, what should I invest in?

I am asked this often, and it’s a question I can’t answer. Why? … Because your goals of financial freedom are very personal, and they depend on what you want to accomplish in life.

And for many of you out there, this may be a new concept. Instead of thinking about your children, spouses, friends, aging parents, and others first, you actually need to focus on what you want.

Up until now, you’ve probably thought the only way to make money was to go to your job every day, and collect a biweekly paycheck in exchange for your work. Most people make money this way, because it's what they are taught to do by their parents or teachers. Also, it feels like a safe and secure path because it’s the traditional route.

Well, what if I told you that there’s another way? Another path in life that doesn’t require you to trade time for money? A path that allows you to follow your passion, achieve financial freedom, and reach your life goals? Now I’ve piqued your interest, right?

This path is precisely how the rich make their money — and it’s not from an hourly wage or salary. Instead, they make their money from their investments. In fact, the best way to make money is as an investor — but the question I’m often asked is: How do you make that money? If your monthly income as an investor does not come from a job, then where does it come from?

Be Clear in Your Investment Goals

As you increase your financial education and conduct research, you’ll find that there are many investments out there. Most of the major financial magazines and television shows focus on stocks, bonds and mutual funds, also known as paper assets.

Many of the financial “experts” out there promote these investments as less risky and the “safe” way to go. And those who do not have financial intelligence often just hand their hard-earned money over to these people. Why not? It’s easy just to let someone else handle their finances so they don’t have to think about it!

But know that there are many, “alternative-investments” available to help you reach your goals of financial freedom.

Pay attention to the investment areas that you find most interesting. It’s crucial you choose the asset that best suits your personality, values and lifestyle. After all, being an investor is a lifelong activity so you want to find something that you’ll actually like to study. The one thing to remember along the process is that the ultimate goal is that you make your money work for you.

Making Your Money Work for You

If there’s one thing the rich do differently than the poor, it’s that they put their money to work instead of working for their money. What does that mean? Their money isn’t just sitting around in a savings account, accruing little-to-no interest, waiting for a rainy day. Their money is being invested — and delivering a return!

Different investments produce different results. The question is, what results do you want?

There are two primary outcomes an investor invests for:

Investor Income #1: Capital Gains

If you enjoy watching those “fix it up and flip it” TV shows, you’re probably already familiar with the concept of capital gains — essentially, it’s the game of buying and selling for a profit.

In real estate, let’s say you buy a single-family house for $100,000. You make some repairs and improvements to the property, and you sell it for $140,000. Your profit is termed “capital gains.” Any time you sell an asset or investment and make money, your profit is capital gains. Of course, there are also capital losses (which occur when you lose money on a sale).

The same concept holds true outside of real estate. If you buy a share of stock for $20, and sell it once the stock price increases to $30, that’s also a capital gains profit.

The Challenge with Capital Gains

While there is money to be made through capital gains, it’s also important to note the risks.

First, it’s a formula you have to keep repeating over and over again — you have to keep buying and selling, buying and selling, and buying and selling, or the game and the income stop.

Second, if the real estate market takes a nosedive, “flippers”— people who buy a real estate property and quickly turn around and sell it for a profit, or capital gains — can get stuck with inventory they can’t sell.

Before the housing bubble burst in 2008, the mindset for many was that the market would continue to go up. So, when the market reversed and crashed, the properties were no longer worth what the flippers bought them for, and there were no buyers to flip the properties to. This led to a record-breaking number of foreclosures, and people simply walking away from homes.

Most investors today are chasing capital gains in the stock market through stock purchases, mutual funds, and 401(k)s. These investors are hoping and praying the money will be there when they get out. To me, that’s risky.

As long as market prices go up, capital-gains investors win. But when the markets turn down and prices fall — something nobody can predict — capital-gains investors lose. Do you really want that gamble?

Investor Income #2: Cash Flow

Cash flow is realized when you purchase an investment and hold on to it, and every month, quarter, or year that investment returns money to you. Cash-flow investors, unlike capital-gains investors, typically do not want to sell their investments because they want to keep collecting the regular income of cash flow. If you aren’t already familiar with my motto, cash flow is queen!

If you purchase a stock that pays a dividend, then, as long as you own that stock, it will generate money for you in the form of a dividend. That is called cash flow. To cash flow in real estate, you could purchase a single-family house and, instead of fixing it up and selling it, you rent it out. Every month you collect the rent and pay the expenses, including the mortgage. If you bought it at a good price and manage the property well, you will receive a profit, or positive cash flow.

The cash-flow investor is not as concerned as the capital-gains investor whether the markets are up one day or down the next. The cash-flow investor is looking at long-term trends and is not affected by short-term market ups and downs — what a great position to be in!

The Advantage of Cash Flow versus Capital Gains Investing

The best thing about cash flow is that it’s money flowing into your pocket on a continual basis — whether you're working or not. You could be on the golf course, jet-setting around the world, watching Netflix in your jammies, or building a business, and your money is busy working for you. And generally, cash-flow investing is based on fundamentals that aren't as susceptible to market swings like capital-gains investments, which means that even in bad times, money still flows into your pockets.

Additionally, cash flow is what is known as passive income, which is the lowest taxed type of income. This is not always the case with capital gains taxes, which vary depending on the type of asset you've invested in and how long you've owned that asset. In some cases, the taxes can be very high.

If you’re ready to start enjoying the lifestyle advantages of cash flow, don’t miss my blog on getting started with real estate. Otherwise, to conduct more research on various investments and start your journey to financial freedom, check out our free, financial education community here.

Original publish date: September 12, 2013

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