Profiting From the Irrationality of Others

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Generations of investors have blindly accepted economists' assumption that humans behave rationally -- that every decision we make derives from a cool and calculated balancing of all conceivably related benefits and costs.

What if I were to tell you, however, that this simply isn't true? That humans do not behave rationally -- and that many times, in fact, we behave irrationally. Even predictably so.

Would this change your investment strategies? Would it modify your opinion of what makes a company great? Or would it lead you into the comforting embrace of guns and gold -- the proverbial staples of chaos?

Regardless of your answers to these questions, the truth is that we aren't rational. We prefer Coke over Pepsi, yet choose the latter when subjected to a blind taste test. We buy new as opposed to used cars despite the immediate and usurious depreciation incurred upon leaving the dealer's lot. And each morning we happily fork over $4 for a few cents' worth of milk and concentrated coffee that we've been programmed to call a "grande latte."

Yet all is not lost, dear investor, for as you'll see, the acknowledgment of this irrationality could be your biggest competitive advantage. In fact, if you're anything like me, it may even change the type of companies you choose to invest in. So without further ado, we begin the first in a series of articles on irrational yet predictable behavior by discussing our perceived preferences for pop.

Why Coke is better than Pepsi
For as long as I can remember, Coca-Cola (NYS: KO) and PepsiCo (NYS: PEP) have been locked in a heated rivalry over the relative merits of their flagship sodas. While PepsiCo's television ads claim people prefer the taste of Pepsi over Coke, Coca-Cola's ads proclaim just the opposite. But how could this be? Is each company cooking the books in its respective favor? Or is there a less sinister explanation behind these conflicting results?

As Duke Professor Dan Ariely points out in his book PredictablyIrrational, the answer lies in the different ways the companies evaluate their products. While PepsiCo uses a blind taste test to assess the differences, Coca-Cola lets its taste test participants see what they are drinking. A dispassionate observer would accordingly be excused for thinking that, based on taste alone, the average person does in fact prefer Pepsi over Coke. But is this the end of the story? Of course not.

To better understand the Coke vs. Pepsi rivalry, a group of neuroscientists conducted their own taste tests -- only this time, the participants were tested in a magnetic resonance imaging machine so their brain activity could be monitored throughout the test. As Ariely notes in his book, when the participants received a drink, they were presented with visual information indicating either that Coke, Pepsi, or an unknown drink was coming. This way the researchers could record and compare observations under all of the different scenarios.

So what were the results? It turns out that the brain activity of participants did indeed vary depending on whether or not the drink's brand was revealed. When participants weren't informed of the brand, only the center part of their brain was activated, which is associated with strong feelings of emotional connection. When the participants were informed of the brand, however, something additional happened. This time, the frontal area of the brain controlling memory, associations, and higher-order cognition was also activated -- not coincidentally, the frontal lobe is also closely linked to the brain's pleasure center. And the response was strongest when they were drinking Coke, indicating that most people do in fact prefer Coke over Pepsi, but only if they know which is which ahead of time.

The idea of an economic moat
The relationship of a story like this to investing may not be evident immediately. I mean, at the end of the day, who really cares if people prefer the taste of Coke over Pepsi merely because the former's brand is more identifiable?

Yet, it's this seemingly innocuous discovery that reveals how a strong brand can insulate a company even against competitors that offer objectively superior products. It's for this reason, in turn, that brand power forms the core of what Warren Buffett calls the key to investing, an economic moat -- the competitive advantage that one company has over others in the same industry.

So now that you know this, what should you do about it? Well, it's quite simple. When evaluating a prospective stock purchase, ask yourself whether or not the company has a durable competitive advantage. Examples include:

  • Proctor & Gamble (NYS: PG) , with its 24 billion-dollar brands
  • Johnson & Johnson (NYS: JNJ) , with a similarly impressive brand assortment including Band-Aid, Tylenol, and Neutrogena
  • Philip Morris (NYS: PM) and Altria (NYS: MO) , the international and domestic holders of the Marlboro cigarette brand

Beyond that, don't hesitate to use resources that are freely available to you. A perfect example of one is a free report our analysts released detailing a company that's quickly and aggressively digging itself an economic moat akin to Costco's (NAS: COST) . And the added advantage to this company is that the market hasn't caught on to it yet -- so it has the potential for a big-time profit. If you want to access the free report identifying this company before the stock price blows up, click here now -- it's free.

At the time this article was published Fool contributor John Maxfield does not own shares in any of the companies mentioned above. The Motley Fool owns shares of Coca-Cola, Johnson & Johnson, Philip Morris International, Altria Group, PepsiCo, and Costco Wholesale.Motley Fool newsletter serviceshave recommended buying shares of Coca-Cola, PepsiCo, Costco Wholesale, Johnson & Johnson, Procter & Gamble, and Philip Morris International.Motley Fool newsletter serviceshave also recommended creating diagonal call positions in PepsiCo and Johnson & Johnson. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

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