How do capital gains differ from dividends?

The distinction between capital gains and dividends is fundamental in understanding investment returns. Capital gains represent the profit realized from selling an asset, like stocks or real estate, when the selling price exceeds the purchase price. For example, if you bought a stock for $50 and sold it for $70, your capital gain would be $20.

Dividends, on the other hand, are distributions of a company's earnings to its shareholders, typically paid in cash or additional shares. Companies that generate profits may choose to return a portion of those profits to investors as dividends, which can provide a source of income without needing to sell the stock.

This explanation of capital gains and dividends highlights why the second option is the correct answer, as it accurately captures the essence of each term. The nature of these two types of returns is critical for investors to understand when they are building their portfolios or assessing their investment strategies.