Speculation - Type 1 vs. Type 2
We previously wrote about two types of speculation, but yesterday was the first time we explicitly labeled them, calling them Type 1 and Type 2 speculation. We will use today’s post to elaborate on these concepts as we feel they are rather crucial building blocks toward understanding why the definition of investing has gone haywire. This distinction also lays bare the differences between 20th-century finance and 21st-century finance.
You may recognize the terminology from an entirely different context: health. Diabetes is one of the most important health challenges of our times. As the author whose father is a diabetic can attest, it can be quite limiting and harms the body in multiple ways. (Love you Dad! Stay strong.)
You may or may not realize that not all diabetes are created equal. Type 1 diabetes is believed to be caused by an autoimmune reaction and develops early in life. It’s a type of disease that the patient generally has little to no control over. Type 2 diabetes, on the other hand, develops over the course of many years and is related to lifestyle factors such as being inactive and carrying excess weight. The good news is that one can control it to a large degree, and put it into remission with the right lifestyle choices.
Type 1 speculation and Type 2 speculation have some similarities to this medical dichotomy. Type 1 speculation, even for the self-aware, may be difficult to identify. It inherently involves elements of subjectivity (when estimating the value of a cash-flow-generating asset), and it occurs on a spectrum. It also occurs somewhat naturally in the sense that it is a byproduct of having capital markets that are, net-net, beneficial for the public. As a result, there is only so much the regulator can do to control Type 1 speculation.
Type 2 speculation, on the other hand, is generally not about capital generation. Type 2 diabetics need to know, first and foremost, that what they have is Type 2 (diagnosis) and also that they can manage it fairly well if they are willing to make the right lifestyle choices (treatment). This makes it an informational disclosure issue followed by the willingness of the patient to impose self-discipline. Similarly, when it comes to Type 2 speculation, both the regulators and the market participants have a greater degree of control. With the right regulatory structure, Type 2 speculation can be managed, or even put into remission.