Competitive advantages are important in all aspects of life. Whether it's the advantage the Green Bay Packers have in December when they play at home or the cost advantages Wal-Mart has over mom-and-pop stores, such advantages are integral to enduring success in a dog-eat-dog world.
One type of advantage that is misunderstood and generally overlooked in the investing world is that of the network effect. For the purposes of this article, let's define network effect as:
The effect that occurs when someone becomes a user of a service, thereby increasing the value of the service to all other users.
It sounded pretty confusing the first time I read it. So let's unpack the term below, and at the end, we'll see how the network effect plays a huge role in the market's hottest field: social media.
What program do you write with?
Perhaps the most dominant form of network effect over the past 20 years comes from Microsoft's
When I had to buy my first cell phone in college, I checked with all of my roommates to see what carrier they were using. Because almost all companies offer free calls to users of the same network, we all wanted to be on the same network.
Though I'm proud to say I'm not quite as cheap as I was in college, I still like saving money; I still check to see what service my friends and family are on before deciding on a provider. Companies such as Sprint Nextel
If you sit down and think about it for a while, travel sites are able to exploit this effect as well. For every user who bids for something on priceline.com
The same can be said for Travelzoo
The next bubble?
With the astounding bump that social-media site LinkedIn
If my brothers and I were the only ones on Facebook, LinkedIn, Twitter, or any other social media site, it wouldn't have much value to the community at large. But as more people join, these sites become exponentially more valuable.
But here's the catch ...
While the network effect can, as I said above, increase the value exponentially with each additional user, the reverse is true as well. Just as value can go up, it can decrease exponentially once users start switching away from a service. That's why investors in Activision Blizzard
If you want to keep an eye on such effects, watch the stocks that benefit from them:
Fool contributor Brian Stoffel isn't a user of LinkedIn, but he will be someday. He owns shares of Travelzoo and Activision Blizzard.
The Motley Fool owns shares of Microsoft, Wal-Mart, and Activision Blizzard. Motley Fool newsletter services have recommended buying shares of Activision Blizzard, Wal-Mart, Microsoft, priceline.com, and AT&T, as well as creating a diagonal call position in Microsoft and Wal-Mart and creating a synthetic long position in Activision Blizzard.