Capital Appreciation: Meaning, Types and Examples

What Is Capital Appreciation?

Capital appreciation is a rise in an investment's market price. Capital appreciation is the difference between the purchase price and the selling price of an investment. If an investor buys a stock for $10 per share, for example, and the stock price rises to $12, the investor has earned $2 in capital appreciation. When the investor sells the stock, the $2 earned becomes a capital gain.

Understanding Capital Appreciation

Capital appreciation refers to the portion of an investment where the gains in the market price exceed the original investment's purchase price or cost basis. Capital appreciation can occur for many different reasons in different markets and asset classes. Some of the financial assets that are invested in for capital appreciation include:

• Real estate holdings
• Mutual funds or funds containing a pool of money invested in various securities
• ETFs or exchange-traded funds or securities that track an index such as the S&P 500
• Commodities such as oil or copper
• Stocks or equities

Capital appreciation isn't taxed until an investment is sold, and the gain is realized, which is when it becomes a capital gain. Tax rates on capital gains vary depending on whether the investment was a short-term or long-term holding.

However, capital appreciation isn't the only source of investment returns. Dividends and interest income are two other key sources of income for investors. Dividends are typically cash payments from companies to shareholders as a reward for investing in the company's stock. Interest income can be earned through interest-bearing bank accounts such as certificates of deposits. Interest income can also come from investing in bonds, which are debt instruments issued by governments and corporations. Bonds usually pay a yield or a fixed interest rate. The combination of capital appreciation with dividend or interest returns is referred to as the total return.

Causes of Capital Appreciation

The value of assets can increase for several reasons. There can be a general trend for asset values to increase including macroeconomics factors such as strong economic growth or Federal Reserve policy such as lowering interest rates, which stimulates loan growth, injecting money into the economy.

On a more granular level, a stock price can increase because the underlying company is growing faster than competitor companies within its industry or at a faster rate than market participants had expected. The value of real estate such as a house can increase because of proximity to new developments such as schools or shopping centers. A strong economy can lead to increases in housing demand since people have stable jobs and income.

Investing for Capital Appreciation

Capital appreciation is often a stated investment goal of many mutual funds. These funds look for investments that will rise in value based on increased earnings or other fundamental metrics. Investments targeted for capital appreciation tend to have more risk than assets chosen for capital preservation or income generation, such as government bonds, municipal bonds, or dividend-paying stocks. As a result, capital appreciation funds are considered most appropriate for risk-tolerant investors. Growth funds are customarily characterized as capital appreciation funds since they invest in the stocks of companies that are growing quickly and increasing their value. Capital appreciation is employed as an investment strategy to satisfy the financial goals of investors.

Capital Appreciation Bond

Capital appreciation bonds are backed by local government agencies and are therefore known as municipal securities. These bonds work by compounding interest until maturity, which is when the investor receives a lump sum that includes the value of the bond and the total accrued interest. Appreciation bonds differ from traditional bonds, which typically pay interest payments each year. 

Example of Capital Appreciation

An investor purchases a stock for $10, and the stock pays an annual dividend of $1, equating to a dividend yield of 10%. A year later, the stock is trading at $15 per share, and the investor has received a dividend of $1. The investor has a return of $5 from capital appreciation as the price of the stock went from the purchase price or cost basis of $10 to a current market value of $15 per share. In percentage terms, the rise in the stock price led to a 50% return from capital appreciation. The dividend income return is $1, equating to a return of 10% in line with the original dividend yield. The return from capital appreciation combined with the return from the dividend leads to a total return on the stock of $6 or 60%.