Investing > Mosaic Theory 101

Mosaic Theory 101

The mosaic theory is a surprisingly holistic approach to market analysis—and a perilous trap for the unwary.

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Updated January 09, 2022

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It’s no secret that it was the IRS which ultimately got Al Capone.

What is less known is the operation that first cracked the vulnerability of the famous gangster. In 1929, several years before he was sentenced to his career-killing 11 years in prison, Capone was imprisoned for contempt of court after he lied to evade testifying in a prohibition-related case in front of a federal jury in Chicago.

The information was carefully gathered by the FBI from eyewitnesses of the gangster’s escapades undertaken while he was allegedly mortally ill. The bureau had to be very careful to stick to public information so as not to blow the case on the grounds of illegal surveillance.

And they succeeded, unlike in the almost-a-century-later scandal regarding mass government surveillance where the individual information collected was considered public and legal. But the sum of it all encroached too much on the “reasonable expectations of privacy” of the citizens and was thus unconstitutional.

In 2005 Michael Burry famously looked where nobody else bothered to—in the composition of mortgage-backed securities—painstakingly building a case out of various information about systemic weaknesses which culminated in the bet of a lifetime.

The mosaic theory is the idea that a sum of smaller, often publicly available information can give you deeper insights into a business’s health and help inform and improve your investments. 

All three of these cases—while coming from different fields—share aspects, strengths, peculiarities, and weaknesses of the mosaic theory. So let’s learn how you can be more like the FBI of the 20s and less like the NSA of the 2000s.

What you’ll learn
  • What is the Mosaic Theory?
  • How Does Mosaic Theory Work?
  • Dangers of Using Mosaic Theory
  • The Legality of the Mosaic Theory
  • Mosaic Theory Alternatives
  • Conclusion
  • FAQs
  • Get Started with a Stock Broker

What is the Mosaic Theory? 📚

The Mosaic theory is less a theory than a method. The basic idea is that you would try to collect bits and pieces of information about a company so that you could try to predict good investments based on its overall financial health.

These bits and pieces fall under private and public, and material and non-material information. Basically, public means that is openly disclosed and private that it isn’t, while material information has a direct impact on stock prices, and non-material doesn’t. Don’t worry, we’ll be diving into these concepts more thoroughly a bit down the line.

The big issue with the mosaic theory is that it features quite a bit of legal ambiguity and small missteps could lead you down the path of punishable-by-jail insider trading.  A very explicit example of this danger is the U.S. Court of Appeals stated in the U.S. v. Teicher case from the early 90s that material information “cannot lay idle in the human brain.”

On the other hand, succeeding in using the theory correctly could ensure you make an investment of a lifetime.

How Does Mosaic Theory Work? 🕵️‍♂️

The mosaic theory functions by piecing together material and non-material information to concoct a strategy—with a big emphasis on not using material private information. This is a very difficult course to keep as even if you do manage it, the law might still suspect you of insider trading.

The sources of information that are used in the mosaic theory methodology
One of the unique characteristics of the mosaic theory is its focus on non-fundamental and speculative private data.

So, what are all these different kinds of information?

Public and private information are rather self-explanatory. Public information is information disclosed to the general public like when Disney announced its merger with Fox in 2019 or every year Apple reveals the new iPhone.

Private information is confidential and generally unavailable. It can, obviously, be obtained in various ways from talking with employees to overhearing the CEO and the CFO talking in a cafe to coming across leaked information.

The bigger difference is that between material and non-material information.

Material Information 📝

Material information is any and all information that directly affects the prices of a company’s shares. This is a very broad category—but just to get an idea—reports on quarterly performance, dividend yields, and management changes are often considered prime examples of material examples.

Once again, the difference between private and public material information is rather self-explanatory—if the report on quarterly performance has been released to the public it is public information, if it is still available only to authorized personnel within the company, it is private.

For example, senators Richard Burr and Kelly Loeffler got into trouble early into the COVID-19 pandemic. They were privy to the potential scope of the outbreak before the general public and swiftly sold a lot of stocks in anticipation of the coming economic turmoil.

This same case showcases how tricky discerning between legal and illegal actions can be since, as of October 2021, the investigation is still underway

An example of public material information—and thus legal to use within your mosaic-theory-built investment strategy—would be that time in early 2019 when Activision Blizzard reported record profits and fired 800 people. This information did ultimately lead to a price jump from around $42 to around $47 despite people rallying behind the by then ex-employees.

Non-Material Information 💭

That rally behind the fired employees could be considered non-material information though it did lead to price changes. After that initial increase to around $47 the shares’ value did drop to a bit more than $43 for a few months after the controversy before ultimately rising again.

Other information often considered non-material is employee satisfaction which can be gathered through conversation, reading of tweets and Reddit posts, through LinkedIn, and various other ways you could think of.

Another form of non-material information is the general public’s interest in the company. One way of gauging this is by checking the Google search popularity of a business. 🔍

One anecdote about gathering non-material information comes from a university in Texas. Around 2005, a certain professor noticed that all of their colleagues and Ph.D. students were suddenly using Apple computers. While Macs were always at least somewhat popular in academia, their prevalence was going through the roof.

The professor did get the idea that the stock prices would soon start skyrocketing but never really followed through—which is something we are certain they aren’t regretting at all.

Belonging to the Muses 🧮

The mosaic theory is often described as equally an art as a science. We, however, feel it certainly falls much more under art and crafts. While somewhat formalized and very meticulous, there are far too many variables for the predictions made using this method to be much more than educated guesses.

That being said, these predictions can still be very accurate. A rule of thumb when analyzing the market—particularly regarding technical analysis—is the more the merrier. Essentially, the more indicators and sources pointing to an outcome you find, the better the chances are of your conclusions being right. The mosaic theory, by its very nature, lends itself well to this philosophy.

The mosaic theory certainly has an advantage from the get-go here as it inherently incorporates a wide variety of information from a wide variety of sources. You should remember, however, that every art and craft demands a lot of practice before it can be perfected. The mosaic theory is no exception and it can be easy to come to the wrong conclusions—or thread the legal-illegal border a bit too carelessly.

Dangers of Using Mosaic Theory ⚠

Unofficially, there are two kinds of screenwriting—the white elephants writing and the termites writing. A similar division can arguably be applied to stock analysis. While anecdotes are unbefitting of a proper systematic examination, the story about the Texas professor is very true and can be considered a tale of a white elephant—of a person finding a smoking gun. 

They were right in their case, but even if they followed through they still could have lost a lot of money by following just one lead. For another hypothetical example of being blind-sighted by a gorgeous huge mammal, let’s look at Boeing.

The Trouble With Elephants 🐘

Perhaps you remember a very high-profile crash of a 737 Max 8 in Ethiopia in 2019 which Boeing took full responsibility for in Autumn 2021.  The keen-eyed practitioners of the mosaic theory might have noticed an earlier crash of the same model earlier in 2019 in Indonesia and a design flaw of the aircraft which caused it.

It would be reasonable to assume that Boeing would face a reckoning for their practically malicious negligence on the market just like in the courtroom—and thus to see a shorting opportunity.

Boeings full responsibility
The news of Boeing’s full responsibility for the crash led to strange 5-day price jump followed by a 46% drop in share value over the next two weeks. Image by TradingView.

On the one hand, this would have been in accordance with the mosaic theory as It took into account not-material information about both the future liability of the firm and the potentially harmful business practices within Boeing. On the other, it would have been a case of white elephant screenwriting—a single big event driving your conclusions and further strategy.

Boeing’s shares kept steadily rising after the crash and took nearly a whole week to start falling even after the court ruling.

We could also look at a less grim, more hypothetical case. Since one of the possible ways of collecting non-material information is through gauging employee satisfaction you could stumble upon a Reddit thread started by an employee of company X.

They could be ranting and raving about horrible conditions within company X that could lead you to believe that the company is a sinking ship. This could prove to be correct so going to a great short-selling broker could garner you a major payday, or they could just be recently fired and very disgruntled causing you to make a very bad bet.

A Colony of Termites 📙

Too many cooks spoil the dish is the saying, and it describes a weakness of the mosaic theory. The screenwriting of termites is the idea that rather than focusing on one big gimmick—a smoking gun—you build your story up using numerous smaller harmonious threads.

This would also be the ideal of the mosaic theory—to build up your analysis and reach your conclusions from many pointers giving off the same thing. However, it is very difficult to have a Ph.D. in everything and you run the risk of misunderstanding certain information.

Furthermore, you could also miss the forest for the trees—have a bigger picture obscured by a huge pile of data. This issue could go even further if you came to your conclusions early in the analysis and allowed yourself to force the pieces to fit. 🕵️‍♂️

Finally, the issue with utilizing data from many sources is that you can become too good at spotting minor important things. While this appears to be a good thing at first glance, you must keep in mind what ultimately dictates stock prices.

As one of the core tenets of the Dow theory states—volume must confirm the primary trend. It is of little use to you if you are one of ten people who have noticed something that should bring the shares of a company down—or prop them up—among a million other investors oblivious to it.

This would be THE investment to make it the factor you spotted was a company-killer, but if it was more about a potential investor scare or craze it would be futile if nobody else saw it and got terrified or excited about it.

Caution and practice are the main ways of avoiding these pitfalls. As long as you practice a lot with the amount of money you can afford to lose, and stick to pointers you understand, the termites shouldn’t be able to eat through your investment strategy. 🎯

You should also diversify before attempting anything risky—index funds tend to be a good way of doing this and they have grown in popularity throughout the 21st century for a good reason. They simply follow the winds and the winds tend to be favorable in a bull market—and they keep outperforming most professional fund managers.

Ball and Chain 🔗

While making a bad investment because of a misstep with the mosaic theory can hurt, the effects of misusing it can be downright catastrophic. Since a big part of this method can be very close to using private material information, it is very easy to find yourself on the wrong side of the law.

For this reason, it is generally best to keep a close eye on the data you are analyzing and steer clear of anything you aren’t entirely certain is legal.

The consequences of being suspected and accused of insider trading are dire in nearly all cases—even if you are found not guilty. It often takes a long time to reach a definitive ruling, once again due to how ambiguous the law can be. So, you would most likely be facing months of stress and harassment at the very least.

And if found guilty, you could be facing a long prison sentence and the loss of all your winnings that are deemed to be unjustly gained. So, to prevent any potential inconvenience, you should make sure you keep tabs on where you got all your information while using the mosaic method. That way, even if the feds get inquisitive, you can easily prove that you’ve done nothing wrong.

The final word of warning here is that you should also be careful about the broker you choose—you can be found complicit in insider trading vicariously just by using a broker guilty of it. That is one of the many reasons why it’s better to use one of the well-established premium stock brokers over untested brokerages.

The Legality of the Mosaic Theory 🛡

With all of that being said, the mosaic theory is entirely legal and entirely valid. Furthermore, while it can definitely be dangerous, various SEC regulations regarding corporate transparency have made it relatively easy to get all the information you need in order to effectively use the mosaic theory.

However, despite being retained under the SEC’s fair disclosure act, the mosaic theory can’t be used as a get-out-of-jail-free card. In fact, the one time this method was attempted as a defense in a court of law it failed miserably.

Raj Rajaratnam, the founder of The Galleon Group was sentenced to 11 years in prison in 2011 on 14 counts of insider trading. His lawyers did attempt to argue that it wasn’t insider trading and that Raj and his associates were simply utilizing the mosaic theory, but they were unsuccessful. 

Mosaic Theory Alternatives 📃

The scuttlebutt method is often mentioned among the mosaic theory’s alternatives. However, it is actually its less formal cousin. This method has been popularized by Phil Fisher and it focuses on information collection through human interaction—talking to and gathering data from employees, customers, etc. It is primarily intended for investors who are either semi-experts or don’t have access to professional services.

So, there is no definitive alternative to the mosaic theory. Rather, it should simply be used as one of the many tools alongside technical and fundamental analysis. Generally speaking, it is best to use as many different gauging methods as you are comfortable with since the more sources corroborate the same conclusion the higher the likelihood of it being right.

That being said, if you aren’t comfortable with the risk of legal repercussions, you shouldn’t be too embarrassed if you choose to skip it altogether. Nowadays, even the top mobile stock trading apps offer more than enough different analysis tools to make the mosaic theory feel like a bonus rather than a necessity.

Conclusion 🚩

With its holistic approach to investment strategy, the mosaic theory certainly isn’t without merit. Since it takes into account so much information that many of the other analysis tools—which tend to be far more chart-focused—ignore, it is capable of leading you to conclusions you would’ve otherwise completely missed.

However, it suffers from a problem that is very common among analysis tools—it ultimately leads to an individual judgment call and is thus susceptible to human error. Furthermore, the fact that messing up and crossing the line into using private material information can get you into a lot of legal trouble certainly means that being extra cautious isn’t just advisable, but necessary.

Mosaic Theory: FAQs

  • Is the Mosaic Theory Illegal?

    The mosaic theory is legal and considered valid. The trick is that you are legally allowed to use public and private non-material information and public material information. The use of private material information is considered insider trading and punishable by law.

  • What is the Difference Between the Mosaic Theory and the Scuttlebutt Method?

    The scuttlebutt method is the less formal variant of the mosaic theory. It is intended for semi-experts and people without access to professional advice. It mainly focuses on collecting information about the health of a business by talking to people associated with it—both on the customer and employee sides

  • Who Uses Mosaic Theory?

    The mosaic theory is mostly used by professional market analysts due to them having access to more information that can legally be used when formulating an investment strategy than the average investor. The scuttlebutt method is a variant of the mosaic theory intended for more casual retail investors. 

  • What Type of Information is Used in the Mosaic Theory?

    The mosaic theory uses public and private non-material information and public material information. Material information is the information that directly affects stock prices such as mergers, quarterly reports, and management changes. Non-material information doesn’t directly relate to stock prices and can, for example, be overall consumer satisfaction with a company, or its popularity among Google search results.

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