There are two main ways in which a person gains from an investment. The first is by capital gains, which is the difference between the purchase price and the sale price of an investment. The second is investment income, defined as the money paid to the holder of an investment by the issuer of the investment. Depending on the type of investment, the source or mix of the total gain will differ. And in some cases, these different sources are taxed at different rates, so it is important to be aware of each.
How Gains in Stocks are Determined
All stocks can generate a capital gain as the price of a stock is constantly changing in the market. This allows you to potentially sell for a higher price than what you bought the stock for originally. Some stocks also generate income gain through the payment of dividends paid out by a company from its earnings.
For example, say that you bought a stock for $10 and the company pays off an annual dividend of $.50, and after two years of holding the stock you sell it for $15. Your capital gain is 50 percent ($5/$10) and your income gain is ten percent ($1/$10) for a total gain of 60 percent (or $6/$10).
(For more, check out How Stocks Trade in our Stocks tutorial.)
How Gains in Bonds Are Determined
Bonds are typically known for their payment of coupons, which is an income source of gain. However, a person also can generate a capital gain from a bond by selling the bond before maturity into the secondary market.
For example, if you bought a bond for $1,000 and sold it for $1,100, you would realize a capital gain along with any income gain from coupons paid out to you. There is an inverse relationship between bonds and interest rates, the price of a bond will change in the opposite direction of the prevailing interest rates in the market. If interest rates fall, your bond will become more attractive in the market and an upwards bid should be expected.
(For more information on gains, see our Investing 101 tutorial.)