Why Do Investments in Stock Result in Capital Gains or Losses?
A stock's price is tied to the market's perception of a company's value. Understand the dynamic forces that alter this perception, creating a gain or loss.
An investment in stock results in a capital gain or loss because a stock’s price changes over time. The gain or loss is the mathematical difference between the price an investor pays for the stock—the purchase price—and the price they receive when they sell it. If the selling price is higher than the purchase price, it is a capital gain, while a lower selling price results in a capital loss.
What Determines a Stock’s Price
A share of stock represents a small fraction of ownership in a publicly traded company. Its price is not set by the company but is determined in the stock market through the interplay of supply and demand. When more investors want to buy a stock than sell it, the price tends to rise. Conversely, when more investors are looking to sell, the price typically falls.
This dynamic occurs as buy and sell orders are matched. A “bid” is the price a buyer is willing to pay, while an “ask” is the price a seller is willing to accept. The price at which a trade occurs becomes the new market price, constantly updated with each transaction and reflecting all publicly available information about the company.
Forces That Cause Stock Prices to Change
The supply and demand that dictate a stock’s price are influenced by a continuous stream of new information. This information can be broadly categorized into company-specific factors and wider economic forces. Each piece of new data can shift investor perception and, consequently, the price they are willing to pay for a share.
Company-specific factors relate directly to the business’s performance and operations. Publicly traded companies publish regular financial reports on earnings, cash flow, and forecasts. A company reporting higher-than-expected profits can see its stock price increase. Conversely, news of declining sales or an accounting scandal can cause the price to fall. Other influential events include a new product announcement, a change in leadership, or a merger.
Broader market and economic factors also have a significant impact on stock prices. The overall health of the economy, measured by indicators like Gross Domestic Product (GDP), plays a large role. Higher interest rates set by central banks can make lower-risk investments like bonds more attractive, drawing money away from stocks. Inflation and geopolitical events that create uncertainty can also lead to widespread selling and lower stock prices.
The Act of Selling to Realize a Gain or Loss
The fluctuation of a stock’s price creates potential gains or losses, but these are not finalized until the stock is sold. An increase in value is considered an “unrealized gain” because it only exists on paper. The gain becomes a “realized gain” at the moment of sale, which is a taxable event. The same principle applies to losses, which only become realized for tax purposes when the position is closed.
To calculate the gain or loss, an investor must determine their “cost basis.” The cost basis is the original purchase price of the asset, including any commissions or fees paid. For example, if you purchased 100 shares of a stock at $50 per share and paid a $10 commission, your cost basis would be $5,010. If you later sell those shares for $7,000, your realized capital gain is $1,990.
The Internal Revenue Service (IRS) requires taxpayers to report realized capital gains. The tax rate applied depends on how long the asset was held. Assets held for one year or less generate short-term capital gains, taxed at ordinary income rates. Assets held for more than a year generate long-term capital gains, which are taxed at lower rates of 0%, 15%, or 20% depending on the taxpayer’s income.
How Dividends Differ from Capital Gains
While capital gains come from a stock’s price appreciation, dividends are a different type of return. A dividend is a distribution of a company’s profits to its shareholders, typically paid on a regular schedule.
A capital gain is generated by selling the asset for more than its cost basis. A dividend, however, is a separate cash payment for holding the stock, regardless of its price movement. An investor can receive dividend income while also having an unrealized gain or loss on the stock.
The tax treatment for dividends also differs. They are categorized as either “qualified” or “ordinary.” Qualified dividends meet certain IRS requirements and are taxed at the lower long-term capital gains rates. Ordinary dividends are taxed at the investor’s higher ordinary income tax rate.