Capital Gains

A capital gain is the delightful profit you earn when you sell an asset for a higher price than you originally paid for it. Think of it as the 'profit score' in the game of investing. Whether you're selling a stock, a bond, a piece of real estate, or even a valuable piece of art, the positive difference between the selling price and your initial cost is your capital gain. This is one of the two main ways to make money from investing, the other being income (like dividends from stocks or interest from bonds). For many investors, particularly those following a value investing philosophy, the patient pursuit of capital gains by buying and holding quality assets is the primary path to building long-term wealth. It’s the reward you get for making a smart purchase and having the patience to let its value grow over time.

The math behind capital gains is refreshingly simple. To find your gain, you just subtract the original purchase price (your cost basis) from the final selling price. The Formula: Selling Price - Cost Basis = Capital Gain For example, if you buy 100 shares of a company for €20 per share (a total cost of €2,000) and sell them a few years later for €50 per share (a total of €5,000), your capital gain is: €5,000 (Selling Price) - €2,000 (Cost Basis) = €3,000 (Capital Gain) Of course, investing doesn't always go up. If you sell an asset for less than you paid, the resulting financial ouch is called a capital loss. In many tax systems, capital losses can be used to offset capital gains, which can be a silver lining during down years.

It’s crucial to understand that not all gains are created equal in the eyes of you or the taxman. They come in two distinct flavors:

• Unrealized Capital Gains: This is a “paper profit.” It’s the gain you have on an investment that you still own. If your stock portfolio has gone up in value by $10,000 this year, you have a $10,000 unrealized capital gain. It feels great, but it’s not cash in your pocket yet. The value could go up further, or it could fall. It's a “potential” gain.
• Realized Capital Gains: This is the real deal. A realized capital gain occurs only when you actually sell the asset. That $10,000 gain becomes realized the moment you hit the 'sell' button and the transaction is complete. This is the point at which the profit becomes yours to spend, reinvest, or—and this is a big one—pay taxes on.

Governments are very interested in your realized capital gains because they are a form of income that can be taxed. To encourage patient, long-term investing over short-term speculation, many countries, including the United States, tax gains differently based on how long you held the asset.

A short-term capital gain comes from selling an asset you've owned for a relatively short period. In the U.S., this is typically one year or less. These gains are usually taxed at your ordinary income tax rate, which is the same rate applied to your salary. This is almost always a higher tax rate, acting as a disincentive for rapid-fire trading.

A long-term capital gain is the profit from selling an asset you've held for a longer duration (e.g., more than one year in the U.S.). These gains are rewarded with preferential tax treatment, meaning they are taxed at a significantly lower rate than short-term gains. For many investors in lower tax brackets, the rate can even be 0%! (Note: Tax laws vary significantly between the U.S. and European countries and can change, so always consult a local tax professional.)

For a value investor, the concept of capital gains is handled with immense patience and a focus on tax efficiency. The goal isn't just to generate a gain; it's to generate long-term capital gains by owning wonderful businesses for many years. Here's why this approach is so powerful:

• The Power of Compounding: By holding an investment and not selling, you allow your unrealized gains to continue growing and compounding tax-free. Selling an asset and realizing a gain forces you to give a slice of your profit to the government, leaving you with less capital to reinvest. By deferring the tax bill, you allow your entire investment to work for you. This is why Warren Buffett famously said, “Our favorite holding period is forever.”
• Focus on Business, Not Speculation: A value investor's primary focus is on the underlying intrinsic value of a business, not its fluctuating stock price. The capital gain is seen as a natural result of the business's success over time. Chasing short-term gains often leads to speculation, higher taxes, and more mistakes. By focusing on the long term, you align your success with the success of the business itself, which is the true spirit of investing.