Capital Growth: Measuring it, Investment Types

What Is Capital Growth?

Capital growth, or capital appreciation, is an increase in the value of an asset or investment over time. Capital growth is measured by the difference between the current value, or market value, of an asset or investment and its purchase price, or the value of the asset or investment at the time it was acquired.

Understanding Capital Growth

The extent of capital growth that's favorable depends on the investor involved and the investment objectives. The investment objective varies among investors, depending on their level of risk tolerance. Investors with low-risk tolerance are likely to seek income, while investors with high-risk tolerance are likely to seek capital growth.

Capital growth investment objectives can be classified into moderate growth and high growth. An investor seeking moderate capital growth might invest in equities of stable companies such as blue-chip stocks. On the other hand, an investor seeking high capital growth might invest in more speculative investments or growth stocks. Growth stocks are often companies with little profit or earnings history that offer the promise of high growth in the future.

Equities and Real Estate

Equities and real estate are two of the most common investments used for capital growth. While these asset classes can have income components—equities through dividends and real estate through rental income—investors with a capital growth investment objective are usually seeking price appreciation.

Diversification

A typical strategy for investors seeking capital growth is to allocate the different investments in a portfolio so that it's diversified. Diversification helps to reduce risk in a portfolio by spreading the investments between different asset classes such as stocks and bonds.

The asset allocation would be determined by various factors such as the investor's objective, risk tolerance, and investment horizon. For example, investors in their twenties would likely opt for more equities or growth companies in their portfolio since they have a long time horizon. On the other hand, investors who are close to retirement might opt for more bonds than equities in their portfolio to create growth with less risk.

The investment objectives and the risk factors would also determine the equity allocation between moderate capital growth investments and high capital growth investments. Each portfolio is different, and each investor's definition of risk is subjective.

Types of Capital Growth Investments

Below are some common investments that might be used in a capital growth strategy.

Funds

Exchange traded funds (ETFs) and mutual funds are funds that contain a basket of securities including stocks or bonds that help investors either diversify risk or target a specific sector. There are ETFs and funds that mirror the S&P 500 (diversified) and those that contain only bank stocks (sector-specific).

Equities

High growth stocks might include technology and biotechnology companies since they often can appreciate significantly over time. However, there is more risk associated with these types of stocks since some of them have to be profitable. Also, not all technology stocks might be growth stocks. For example, some might argue Microsoft Corporation (MSFT) is a well-established company that produces safe and stable returns.

Stocks of companies that have the best capital growth prospects typically do not pay dividends. Dividends are payments to shareholders as a reward for owning shares in the company. Dividends are paid from a company's retained earnings, which is a savings account of accumulated profits over the years. As a result, companies that pay dividends tend to be well-established, consistently profitable corporations.

Companies that don't pay dividends are more interested in generating higher future returns. These growth-focused companies reinvest their profits to fund research and development or to expand operations or infrastructure.

Bonds

Bonds such as U.S. Treasuries issued by the Treasury Department are considered risk-free investments. However, they tend to underperform equities when it comes to capital growth. Bonds are typically used for income since most of them pay a fixed interest rate to bondholders.

REITs

Investors who like the idea of investing in the real estate industry but don't want to own real estate per se can invest in real estate investment trusts (REITs). REITs are funds that contain a portfolio of commercial real estate properties, which can include malls, apartment complexes, hotels, office buildings, and warehouses. REITs offer payments to investors as they distribute the rental income received from the properties.

As with any investment, a capital growth strategy might involve tax ramifications and taxes owed to the Internal Revenue Service (IRS). Please consult a tax advisor for your specific financial situation.

Real World Example

Let's say an investor wants an aggressive capital growth strategy and is willing to take on more risk to achieve higher returns. An individual investing in this portfolio might have a time horizon of 20 years or more. 

Below are different funds and the percentage of the portfolio's total amount invested that would be allocated to each fund.

40% Small-Cap Stocks 

The Vanguard Small-Cap ETF (VB), which tracks the CRSP U.S. Small Cap Index chooses stocks that are considered smaller and riskier but have the potential for high growth. The fund tends to hold technology and industrial stocks.

20% Emerging Markets 

The Vanguard FTSE Emerging Markets ETF (VWO) invests in equities of companies located in emerging markets such as Brazil, Taiwan, South Africa, and China. Emerging market funds like the VWO tend to have a high risk for loss with the potential for high rewards.

20% Large Company Stocks

The Vanguard Large-Cap ETF (VV) invests in stable, large companies like Apple Inc., Johnson & Johnson, Exxon Mobil Corporation, and Visa Inc. The fund provides access to a diversified group of stocks from large U.S. companies.

10% Bonds

The Vanguard Total Bond Market ETF (BND) provides investors with access to many investment grade bonds throughout the U.S. The fund offers income and has very low capital growth through share price appreciation. However, it can help shore up the returns in a portfolio during turbulent markets by adding a steady income stream.

Using the above portfolio as an example, capital growth can be achieved with mutual funds, ETFs, or individual securities. Also, the percentages that were allocated to each fund could be changed to each investor's needs and risk tolerance. For example, an investor that's close to retirement might opt for a higher percentage in the bond fund or the large company fund and a smaller or no allocation in the emerging market fund.