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Keynes once famously said that being successful in the stock market was like judging a beauty contest. The trick is to imagine which model most of the other judges will choose, not who your own personal favourite might be. Sounds easy, but in practice it is one of the hardest things imaginable to do.

In marketing there is something similar, known as the Pepsi Paradox. Over many decades of blind tasting, Pepsi (NYSE:PEP) usually wins but most people still buy Coke (NYSE:KO). Pepsi has a market cap of about $104bn, while Coke’s is valued at more than $120bn. In an era increasingly dominated by social networks and gadgets like the iPhone and Blackberry, a better understanding of consumer psychology could be useful for investment decisions.

The latest scientific research, using fMRI machines to monitor what is happening in someone’s brain when consumers make a buying decision, certainly throws some light on why the iPhone (NASDAQ:AAPL) is poised to outsell the Blackberry (RIMM). The answer can be located in the medial pre-frontal cortex.

In 2004, Read Montegue of Houston’s Baylor College of Medicine, finally nailed what was going on in the brain when consumers taste the two colas. Just under 70 volunteers were first asked to take part in a blind tasting. Just as so often before, Pepsi was the clear winner. What the MRI machine saw was that Pepsi set off greater activity in the ventral putamen area of the brain, compared to Coca-Cola. The putamen is an area cradled deep within the brain in the striatum, which is, among other things, a component of the reward system. In other words, those who drank Pepsi felt just as you would expect them to when sipping sugared water.

In the next series of tests the subjects tasted colas with visible labels. This time round most of the volunteers preferred Coca-Cola. This shift in attitude followed an important change in the brain - this time, the medial prefrontal cortex kicked into action. The cortex was the last area of the brain to develop, it houses our higher cognitive processes. When people tasted Coke this region of the brain overrode immediate feelings of reward evoked by the taste impression. In particular, the medial prefrontal cortex is where elements of our awareness of self and identity are housed. Literally, when you say, “this is so me,” it is your medial prefrontal cortex that is lighting up. Products, such as iPhones, BMWs, Prada bags, trophy wives and certain types of music, light up our medial prefrontal cortex like a pin ball machine.

In the early stages of economic growth capitalism is focused on supplying our basic needs. This is why it makes sense to have a portfolio loaded up with consumer staples when investing in primitively developed economic markets. When you pass a certain point, which is probably when per capita income is close to $4000, capitalism starts entering its medial prefrontal cortex stage. In other words, it becomes increasingly concerned with satisfying our ever shifting sense of self. In a really poor country, very basic mobile phones will be what the market demands. Then, as incomes rise, we lust over an iPhone. At first all we can afford might be a cheap copycat iPhone from a Chinese white-box manufacturer but the goal will always be to buy the real article.

The Theatre of Envy

There is another force at work here and that is the recently discovered mirror neurone. Our brains are peppered with them. Humans and other animals are programmed to copy. The discovery of mirror neurones chimes with a theory long championed by Rene Girard, a noted philosopher and literary critic. Twenty years ago, Girard published an highly influential book called, The Theatre of Envy. Interestingly, this book had a big influence on Peter Thiel, the hedge fund manager and early backer of Paypal (NASDAQ:EBAY).

Girard’s big idea, made before the discovery of mirror neurones, is that our passions and desires are the result of mimicry. Girard identified Shakespeare as one of the leading writers who recognised this basic human truth: if our friend falls hopelessly in love with a woman and starts regaling us with how marvellous she is, the chances are we will also fall in love with her too. There, in a nut shell, is the comedy of human relations and investment bubbles. The discovery of mirror neurones, and into which there is a considerable amount of research being directed, is revealing why the passions and dislikes of others have such an influence over us.

Within the next two or three years, around 3 billion of us - close to half the population of the planet - will be connected to the internet. We will leave it to our readers to reflect on what will happen when passions, preferences and dislikes can be transmitted to millions of people at the speed of light. Now you know why Facebook has just overtaken Google (NASDAQ:GOOG) as the most frequently visited web site on the internet.

Disclosure: I hold no stock positions in any of the companies mentioned.

Source: Pepsi Paradox, Or Why the iPhone Is Poised to Outsell Blackberry