A few months ago my wife asked me to explain to her the difference between interest, dividends and capital appreciation. If we add in income then these are essentially the different ways in which money in an investment can grow. I'll admit that up until now I've probably been a little vague about the distinction between these different mechanisms of growth so I'll try to rectify that in this post.
In the long run, all these forms of growth kind of end up doing the same thing - they all grow your money. And if we draw graphs of investments that experience these different mechanisms of growth then the graphs would look exponential:
These are the same graphs that are produced by the "compound interest" formula that we looked at in an earlier post.
All types of growth can look a lot like a lot like compound interest and they behave a lot like compound interest as well. Money grows at a certain rate per year and in subsequent years you get growth on growth. Compound interest is just a specific type of compound growth.
So if everything kind of looks the same and does the same thing then why is it important to make the distinction between these different mechanisms of growth? Why don't we just call everything interest and be done with it? Two reasons:
Without further delay let's develop a rather silly analogy that will serve to illustrate the distinction between the different mechanisms of growth.
Edgar is the owner of a bakery that specialises in baking with interesting varieties and sizes of eggs - quail (small), duck (medium) and ostrich (large!).
When Edgar does a stock take to see if he has enough eggs to cater for a large retirement party he doesn't worry about how many of each type of egg he has - he is only concerned about the total amount of eggy goodness he has (the rich golden yolk in particular). Quail eggs are the smallest with less yolk per egg, next come duck eggs and lastly the ostrich eggs with lots of yolk per egg.
In our analogy, the amount of eggy goodness or the yolk represents the rand and cents value of our investment. The different types of egg represent a single "unit" of an investment - for example a "unit" in a unit trust, a single share in a company or a gift card.
Let's continue...
It turns out that Edgar has more than enough egg yolk for the retirement party that he needs to cater for. In fact, he has so much extra egg yolk he's able to lend it out (in the form of eggs) to some of his friends who are also in the exotic egg catering business. In return for lending out egg to his friends in need, they will return the amount of yolk that they borrowed plus they will give him some more (either in the form off egg yolk or in the form of eggs). Let's look at these different business dealings in turn.
Edgar earns interest from Alice
For every litre of egg yolk that Alice borrows from Edgar she promises to give him back the original amount of egg yolk plus 10% extra at the end of the year. On 1 January Alice borrows 20 litres of egg yolk. After a successful year in business Alice returns to Edgar on 31 December and gives Edgar 22 litres of egg yolk: 20 litres being the original amount borrowed and 2 litres (10% of 20 litres) being the interest. Edgar now has more egg yolk than he started the year with; his investment has grown.
Edgar receives dividends from Bob
Edgar thinks Bob's Egcellent Eggs, is a great company to invest in and he invests 100 duck eggs in Bob's company. When the company makes a profit, Bob likes to give all the profit to his shareholders - these company profits distributed to shareholders are called dividends. After a great year of business Bob pays Edgar a dividend of one litre of egg yolk. At this stage Edgar could take his egg yolk and make himself a decadent and fancy omelette. But seeing as he's not retired yet, Edgar does best to reinvest his dividends. One litre of egg yolk is roughly the amount of egg yolk in 10 duck eggs so Edgar gives Bob another 10 duck eggs bringing up the total of his investment to 110 duck eggs with a value of 11 litres of egg yolk.
Edgar earns capital appreciation through Cathy
Edgar decides on a long term investment in Cathy's Egg Emporium. He lends her 10 duck egg in January 2000. Cathy is incredibly focused on growing her company. If the company makes any profits, she pours them straight back into the company instead of paying it to the shareholders. So although the shareholders don't get any benefit immediately, they own a share of something that is worth more and their investment has grown. In December 2024 Cathy gives Edgar 10 ostrich eggs. How many eggs did Edgar have in 2000? Ten. How many eggs does he have now? Ten. So Edgar has the same number of eggs, each egg is just worth a lot more (in terms of yolk). This is capital appreciation. With capital appreciation you own the same thing (such as a house) or the same number of things (such as shares in a company), but each thing you own is simply worth more.
Edgar earns (rental) income from Dave
Dave runs a fancy coffee shop frequented by tourists and he thinks having some ostrich eggs on display in the window would be just grand!
He arranges with Edgar to rent 20 ostrich eggs, in return Dave will give Edgar 2 litres of egg yolk (from chicken eggs from the coffee shop kitchen) per year. Assuming that an ostrich egg holds 1 litre of egg yolk, Edgar has received a 10% return on investment (eggs with 20 litres of yolk rented out and returning 2 litres in rental income).
Interest and income
When your investment grows through interest you get more units, but each unit has the same value (each rand is worth one rand, but you have more of them). Interest gets paid to you regularly.
When your investment grows through income you also get more units and each unit has the same value. You also get paid regularly. So income can look a lot like interest. So what's the difference? Consider the example of Alice who paid interest on the borrowed egg yolk and Dave who rented the ostrich eggs from Edgar. The only difference is the form of the asset that was borrowed. Dave was borrowing something that was not egg yolk itself (ostrich eggs) but had a value in terms of egg yolk and he needed to pay rental to enjoy the privilege. Alice was borrowing a certain amount of yolk (which is equivalent to cash in this analogy) and she needed to pay interest for this privilege.
Dividends and capital appreciation
Bob and Cathy represent two extreme ends of the spectrum of how companies decide what to do with their profit. Many companies will pay some of the profits out as dividends to shareholders and retain some of the profits for furthering future growth. When Edgar earned dividends he earned it in the form of egg yolk (the cash currency in this analogy). He then had the option of keeping his dividends or reinvesting by buying more shares of Bob's company (measured in terms of duck eggs in this case). By reinvesting he increases the value of his investment because he has more shares, not because the shares he has are actually worth more. From Cathy, Edgar received no dividends and no intermediate payments. By retaining all the company's profits Cathy was making each share of Bob's more valuable. After 24 years Edgar's 10 eggs invested in Cathy's company were so valuable that he needed to receive ostrich eggs when we cashed in on his investment. In this example he had the same number of units of investment, but each one was worth more.
Remember that interest only barely keeps up with inflation (sometimes it doesn't even do that) so although it's useful it should not be your primary source of investment growth.
You can earn R23 800 worth of interest in a single tax year before you start paying tax on interest earned. You'll need to declare all interest earned from all your investments. You can get this amount by adding up all the amounts labelled "local interest" on the IT3(b) statements that you'll get from your financial management people and banks.
Dividends that you earn are taxed in the hands of the company before they are paid over to you. You'll need to declare all dividends earned in the "other non-taxable income" category on your tax return (and follow the same approach of adding up all the dividend amounts on your IT3(b) statements.
From year to year you'll probably not need to worry about tax on captial appreciation. This is because you'll only pay tax in the year that your investments are sold. This will (hopefully!) result in a large capital gain which follows the rules of Capital Gains Tax as described in the post on tax.
Investment income (such as rental income in the above example) is taxed in the exact same way as your regular income from your job. The full amount is included in your taxable income (no exemptions like interest income or the same benign treatment as capital gains tax)
The four mechanisms of growth that we've discussed so far are not the only ways to grow your investment. You can also manually put money in yourself! This is money that you have saved for the purposes of investment. It's the fuel required for the Financial Independence Engine before it starts running itself.
In the short term, the amount that you are able to put in will far outstrip the investment returns from any of these types of growth. But eventually these growth mechanisms (the backbone behind Pillar Two) will start to earn more than you possibly can. The huge advantage of the investment growth mechanisms discussed in this post is that they are a type of passive income - meaning you don't have to work once they've started out earning you - this is the stage at which you've earned your financial independence.
You might have noticed that depending on how you read the examples of Alice, Bob, Cathy and Dave they could sound a lot like credit and borrowing. Yikes! How did an example about an investment start to sound like an example about borrowing? Investing (or lending as in the example above) goes hand in hand with borrowing. When you invest in some investment product or company they are essentially borrowing money from you. From Edgar's perspective he's investing. From Alice's perspective, she's borrowing (as long as she's borrowing in order to expand her business, that's fine - as long as she doesn't start funding a decadent lifestyle on egg yolk credit!).
In a post that I hope to write soon we'll look at the different options of where to invest in South Africa. In the meantime I hope you've found this post useful!
In the long run, all these forms of growth kind of end up doing the same thing - they all grow your money. And if we draw graphs of investments that experience these different mechanisms of growth then the graphs would look exponential:
These are the same graphs that are produced by the "compound interest" formula that we looked at in an earlier post.
All types of growth can look a lot like a lot like compound interest and they behave a lot like compound interest as well. Money grows at a certain rate per year and in subsequent years you get growth on growth. Compound interest is just a specific type of compound growth.
So if everything kind of looks the same and does the same thing then why is it important to make the distinction between these different mechanisms of growth? Why don't we just call everything interest and be done with it? Two reasons:
- The "rates of growth" typically associated with each mechanism of growth can be very different. So some mechanisms will act faster on your money than others.
- The different growth mechanisms are taxed differently. You need to know how they are taxed so that (a) you can invest in a tax-efficient manner and (b) you know how and where to declare the proceeds of your different investment growth mechanisms (the return on your investment) in your annual tax return.
Without further delay let's develop a rather silly analogy that will serve to illustrate the distinction between the different mechanisms of growth.
Edgar is the owner of a bakery that specialises in baking with interesting varieties and sizes of eggs - quail (small), duck (medium) and ostrich (large!).
 |
| Photos used in the above image (left to right) credited to: Roberto Verzo, snowpea&bokchoi and Beck (all CC-BY 2.0). |
In our analogy, the amount of eggy goodness or the yolk represents the rand and cents value of our investment. The different types of egg represent a single "unit" of an investment - for example a "unit" in a unit trust, a single share in a company or a gift card.
 |
| Egg yolk is the currency in this eggsample :-) Photo credit Emilian Robert Vicol (CC-BY 2.0) |
It turns out that Edgar has more than enough egg yolk for the retirement party that he needs to cater for. In fact, he has so much extra egg yolk he's able to lend it out (in the form of eggs) to some of his friends who are also in the exotic egg catering business. In return for lending out egg to his friends in need, they will return the amount of yolk that they borrowed plus they will give him some more (either in the form off egg yolk or in the form of eggs). Let's look at these different business dealings in turn.
Edgar earns interest from Alice
For every litre of egg yolk that Alice borrows from Edgar she promises to give him back the original amount of egg yolk plus 10% extra at the end of the year. On 1 January Alice borrows 20 litres of egg yolk. After a successful year in business Alice returns to Edgar on 31 December and gives Edgar 22 litres of egg yolk: 20 litres being the original amount borrowed and 2 litres (10% of 20 litres) being the interest. Edgar now has more egg yolk than he started the year with; his investment has grown.
Edgar receives dividends from Bob
Edgar thinks Bob's Egcellent Eggs, is a great company to invest in and he invests 100 duck eggs in Bob's company. When the company makes a profit, Bob likes to give all the profit to his shareholders - these company profits distributed to shareholders are called dividends. After a great year of business Bob pays Edgar a dividend of one litre of egg yolk. At this stage Edgar could take his egg yolk and make himself a decadent and fancy omelette. But seeing as he's not retired yet, Edgar does best to reinvest his dividends. One litre of egg yolk is roughly the amount of egg yolk in 10 duck eggs so Edgar gives Bob another 10 duck eggs bringing up the total of his investment to 110 duck eggs with a value of 11 litres of egg yolk.
Edgar earns capital appreciation through Cathy
Edgar decides on a long term investment in Cathy's Egg Emporium. He lends her 10 duck egg in January 2000. Cathy is incredibly focused on growing her company. If the company makes any profits, she pours them straight back into the company instead of paying it to the shareholders. So although the shareholders don't get any benefit immediately, they own a share of something that is worth more and their investment has grown. In December 2024 Cathy gives Edgar 10 ostrich eggs. How many eggs did Edgar have in 2000? Ten. How many eggs does he have now? Ten. So Edgar has the same number of eggs, each egg is just worth a lot more (in terms of yolk). This is capital appreciation. With capital appreciation you own the same thing (such as a house) or the same number of things (such as shares in a company), but each thing you own is simply worth more.
Edgar earns (rental) income from Dave
Dave runs a fancy coffee shop frequented by tourists and he thinks having some ostrich eggs on display in the window would be just grand!
 |
| Photo credit: Redmond (CC-BY 2.0) |
Cracking open the analogy
Interest and income
When your investment grows through interest you get more units, but each unit has the same value (each rand is worth one rand, but you have more of them). Interest gets paid to you regularly.
When your investment grows through income you also get more units and each unit has the same value. You also get paid regularly. So income can look a lot like interest. So what's the difference? Consider the example of Alice who paid interest on the borrowed egg yolk and Dave who rented the ostrich eggs from Edgar. The only difference is the form of the asset that was borrowed. Dave was borrowing something that was not egg yolk itself (ostrich eggs) but had a value in terms of egg yolk and he needed to pay rental to enjoy the privilege. Alice was borrowing a certain amount of yolk (which is equivalent to cash in this analogy) and she needed to pay interest for this privilege.
Dividends and capital appreciation
Bob and Cathy represent two extreme ends of the spectrum of how companies decide what to do with their profit. Many companies will pay some of the profits out as dividends to shareholders and retain some of the profits for furthering future growth. When Edgar earned dividends he earned it in the form of egg yolk (the cash currency in this analogy). He then had the option of keeping his dividends or reinvesting by buying more shares of Bob's company (measured in terms of duck eggs in this case). By reinvesting he increases the value of his investment because he has more shares, not because the shares he has are actually worth more. From Cathy, Edgar received no dividends and no intermediate payments. By retaining all the company's profits Cathy was making each share of Bob's more valuable. After 24 years Edgar's 10 eggs invested in Cathy's company were so valuable that he needed to receive ostrich eggs when we cashed in on his investment. In this example he had the same number of units of investment, but each one was worth more.
Remember that interest only barely keeps up with inflation (sometimes it doesn't even do that) so although it's useful it should not be your primary source of investment growth.
When you invest in companies through unit trusts, ETFs (Exchange Traded Funds) or actual shares you'll benefit from both dividend income as well as capital appreciation in the long term. Some companies pay out more dividends than others and there are unit trusts and ETFs that try to have a higher proportion of high dividend paying companies.
Rental income is useful (but see the tax implication below) and an easy way to have some exposure to it is through unit trusts or ETFs focussing on owning and renting property. You'll also get some capital appreciation through these unit trusts or ETFs as the values of the properties rise over time.
Tax implications
You can earn R23 800 worth of interest in a single tax year before you start paying tax on interest earned. You'll need to declare all interest earned from all your investments. You can get this amount by adding up all the amounts labelled "local interest" on the IT3(b) statements that you'll get from your financial management people and banks.
Dividends that you earn are taxed in the hands of the company before they are paid over to you. You'll need to declare all dividends earned in the "other non-taxable income" category on your tax return (and follow the same approach of adding up all the dividend amounts on your IT3(b) statements.
From year to year you'll probably not need to worry about tax on captial appreciation. This is because you'll only pay tax in the year that your investments are sold. This will (hopefully!) result in a large capital gain which follows the rules of Capital Gains Tax as described in the post on tax.
Investment income (such as rental income in the above example) is taxed in the exact same way as your regular income from your job. The full amount is included in your taxable income (no exemptions like interest income or the same benign treatment as capital gains tax)
A fifth way of growing your money!
The four mechanisms of growth that we've discussed so far are not the only ways to grow your investment. You can also manually put money in yourself! This is money that you have saved for the purposes of investment. It's the fuel required for the Financial Independence Engine before it starts running itself.
In the short term, the amount that you are able to put in will far outstrip the investment returns from any of these types of growth. But eventually these growth mechanisms (the backbone behind Pillar Two) will start to earn more than you possibly can. The huge advantage of the investment growth mechanisms discussed in this post is that they are a type of passive income - meaning you don't have to work once they've started out earning you - this is the stage at which you've earned your financial independence.
The relationship between investing and borrowing
You might have noticed that depending on how you read the examples of Alice, Bob, Cathy and Dave they could sound a lot like credit and borrowing. Yikes! How did an example about an investment start to sound like an example about borrowing? Investing (or lending as in the example above) goes hand in hand with borrowing. When you invest in some investment product or company they are essentially borrowing money from you. From Edgar's perspective he's investing. From Alice's perspective, she's borrowing (as long as she's borrowing in order to expand her business, that's fine - as long as she doesn't start funding a decadent lifestyle on egg yolk credit!).
In a post that I hope to write soon we'll look at the different options of where to invest in South Africa. In the meantime I hope you've found this post useful!
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