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.
I probably don't have to tell you that this simply isn't true. Humans often behave irrationally – even predictably so.
Responding to irrationality
Should this change your investment strategies? Does 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?
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 hefty depreciation incurred upon leaving the dealer's yard. And each morning we happily spend a few dollars for a few cents worth of milk and concentrated coffee that we've been programmed to call a 'large latte'.
Yet all is not lost. 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.
Why Coke is better than Pepsi
For decades, Coca-Cola (NYSE: KO) and PepsiCo (NYSE: PEP) have been locked in a heated rivalry over the relative merits of their flagship drinks, with both companies claiming that people prefer their product. How is that possible?
As Duke Professor Dan Ariely points out in his book Predictably Irrational, 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.
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 centre 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 centre. 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.
Examples include Woolworths (ASX: WOW), with its huge store network and operational efficiencies, Coca-Cola Amatil (ASX: CCL), with its namesake brand and broad product portfolio and MAP Group (ASX: MAPDA), the majority owner of Sydney airport, a natural monopoly.
Of course, competitive advantages can be eroded over time. Just ask Telstra (ASX: TLS) and the ASX (ASX: ASX), who have both lost their monopoly positions in recent years, or Harvey Norman (ASX: HVN), who first had to battle with then-upstart JB Hi-Fi (ASX: JBH) followed by both price deflation in electronics and the rise of internet retailing.
Foolish take-away
When investing, we're all looking for companies that can continue to grow sales and profits at a good rate over time. Companies with a – sustainable – competitive advantage are the businesses best placed to deliver on that aim. Understanding the sources of advantage – and the threats to that advantage – is an important part of your investing due diligence.
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Scott Phillips is The Motley Fool's feature columnist. Scott owns shares in Coca-Cola, Woolworths, Coca-Cola Amatil, Telstra and Harvey Norman. The Motley Fool's purpose is to educate, amuse and enrich investors. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.
A version of this article, written by John Maxfield, was originally published on fool.com.
