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The Science of Hitting
The Science of Hitting
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Peter Lynch's Two-Minute Drill

January 08, 2012 | About:

In my previous article on Sir John Templetons 16 Rules for Investment Success, I made reference to Peter Lynchs two minute drill; I thought that this topic might be relevant for investors (such as myself) who are vulnerable to the calling of missed opportunities.

Investors are motivated by money, particularly the want to have more of it. When sizing up a potential investment, the reward system within our brains is fraught with activity in anticipation of what might be; as neuroimaging scans have shown, this feeling is created by increased levels of the chemical dopamine in the brain. Harvard researchers have found that this feeling among investors is strikingly similar to the brains of cocaine addicts and morphine users in anticipation of their next score.

Interestingly, neuroimaging studies show that receiving a reward (achieving the gains) is not as satisfying as the anticipation; in fact, when the reward is less likely (for example, picking up a stock near bankruptcy in the hopes of a turnaround and a big payday), the more active your dopamine neurons are, leaving you with a feeling of pleasure and an attraction to taking risks. As noted by Jason Zweig in a 2002 article on the subject, Dopamine makes winning big feel vastly better than just winning and the prospect of its euphoric effect prevents us from focusing on how small the odds of winning big actually are.

As anyone who understands the power of compounding knows, a string of successful years can be woefully diminished by a poor one; for example, an investor who earns 16% per annum does better than someone who earns 20% for nine years and loses just 15% the final year, despite having been beaten 90 percent of the time. As such, its important to realize that the potential outcome of a miscue based on dopamine-induced investments can seriously impact the long term return for a portfolio; this brings us back to Mr. Lynchs two-minute drill.

In the book, Mr. Lynch first recommends that investors learn whatever they can about the story. A current example for someone like Procter & Gamble (PG) would likely include the reading of analyst reports and recent articles about the company, which should highlight the growth opportunity in emerging markets globally for P&G and the potential return to shareholders from capitalizing on this expansion. After this part is completed, the investor can move on to the two-minute drill, which Mr. Lynch describes in his book One Up on Wall Street:

Before buying a stock, I like to be able to give a two-minute monologue that covers the reasons Im interested in it, what has to happen for the company to succeed, and the pitfalls that stand in its path. The two-minute monologue can be muttered under your breath or repeated out loud to colleagues who happen to be standing within earshot. Once youre able to tell the story of a stock to your family, your friends, or the dog (and I dont mean a guy on the bus says Caesars World is a takeover), and so that even a child could understand it, then you have a proper grasp of the situation.

So what should be covered in the two-minute drill? Mr. Lynch suggests discussing the type of company (cyclical, growth, value, etc.), and how its categorization applies to the situation; for example, if youre talking about General Motors (GM), a cyclical company, the talk will likely be about the current business conditions, outstanding inventories, and the effect that supply and demand has had (and will have) on prices. Mr. Lynch closes by saying that he often devotes several hours to developing the script, an indication that this isnt some superfluous exercise for kicks and giggles; this is a necessary step in avoiding potential investment disasters.

As Ive said in previous articles, I think keeping an investment journal is a great way to check your thinking/investment ideas in retrospect. Writing down a two-minute monologue on companies before entering a position is not only a great way to keep yourself in check from making emotionally based decisions, but also a way to solidify your position as a knowledge owner who can calmly hold their position (or add to it) in a company amid unrelated market volatility. And while the researchers say the actual gain may not be good as the anticipation of it, making money doesnt feel too shabby either.

About the author:

The Science of Hitting
I desire to own high-quality businesses for the long-term. In the words of Charlie Munger, my preferred approach is "patience followed by pretty aggressive conduct." I run a concentrated portfolio, with the top five positions accounting for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

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