What it means
Investments can reward you in two ways. Income is cash paid while you hold the asset, such as a dividend from a share or rent from a property.
A capital gain is the increase in the asset's price between the day you buy it and the day you sell it. Return on capital gains isolates the second part.
It takes the gain, divides it by the purchase price and states the result as a percentage. Splitting the return in this way helps an investor see how much of the performance came from price growth and how much from income.
The split matters for several reasons. Tax systems often treat capital gains differently from income, sometimes at a lower rate and sometimes only when the asset is sold.
A growth share that pays no dividends will show all its return as capital gains, while a mature utility may show most of its return as income. Time also matters.
A 40% gain sounds impressive, but earned over ten years it is a modest annual return, so investors usually convert it to an annualised figure. Dividing the total gain by the number of years is a rough guide, while the compound method gives a more accurate picture of the yearly growth rate.
Capital gains are unrealised until the asset is sold. A paper gain can vanish if prices fall before you sell, so reporting return on capital gains should always state whether the gain is realised or unrealised.
Costs of buying and selling, such as commissions and stamp duty, should be deducted to reach a true net figure. Currency can add another layer.
If an investor in one country holds an asset priced in another currency, part of the capital gain may come from exchange rate movements rather than from the asset itself, and a careful report separates the two.
In practice
Real-world examples.
Example
A founder sells a 10% stake in her company for $450,000 after buying it for $300,000 three years earlier. Her capital gain is $150,000, which is a 50% return on the purchase price, before tax and costs.
Example
A retiree holds a share fund that has risen from $200,000 to $230,000 over the past year. He reports a 15% return on capital gains, and then separately adds the $6,000 of dividends to see his total return.
Example
A property investor buys a flat for $400,000 and sells it five years later for $460,000. The capital gain is 15% in total, which is under 3% a year, and she compares this with the rent she earned to judge the overall result. After deducting agent fees and repairs, she finds the rent contributed more to her total return than the price rise did.
Formula
Calculation
Return on capital gains = (Selling price - Purchase price) / Purchase price
Annualised return = (1 + Total return) ^ (1 / Years) - 1
Suppose an investor buys shares for $50,000 and sells them two years later for $72,000. The gain is $72,000 - $50,000 = $22,000, so the return on capital gains is $22,000 / $50,000 = 0.44, or 44%. Annualised over two years, the figure is the square root of 1.44 minus 1, which is 1.20 - 1 = 0.20, or 20% a year.Case study
Seen in the real world.
Marlborough Growth Partners is an illustrative, fictional investment club whose members compared their results at the end of a long bull market. One member boasted of a 60% return, but the treasurer asked how much came from price gains and how much from dividends.
When she broke the figure down, 45 percentage points came from capital gains and 15 from income, and the holding period was six years. The annualised capital gain was about 6.4% a year, far less impressive than the headline.
In this fictional case the club adopted a standard report showing capital gains, income and time held for every investment. Members also agreed to record buying and selling costs so that every figure in the report was net. The illustrative lesson is that the same headline return can hide very different stories once it is split and annualised.
Watch out
Common mistakes.
- Ignoring the length of time over which the gain was earned, which makes slow returns look impressive.
- Treating an unrealised gain as if it were already safely banked.
- Leaving out buying and selling costs, which reduce the true gain.
Questions
People also ask.
Is return on capital gains the same as total return?
No, total return adds income such as dividends or interest to the capital gain, while return on capital gains covers only the price change.
How do I annualise a capital gain?
Take one plus the total return, raise it to the power of one divided by the number of years, and subtract one.
Do capital gains always attract tax?
Not always, because the rules depend on the country, the type of asset and how long it was held, so you should check the position that applies to you.
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