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Active and passive investing are terms well known to the investing community, but what is Mosaic Investing? While Mosaic Investing is not part of the Wall Street lexicon, it does convey meaning to investors who primarily construct portfolios using index mutual funds or index ETFs plus a few individual stocks. Mosaic is to combine diverse elements into a more or less coherent whole. Building a portfolio is this sort of process.

While the overwhelming research argues that passive investing outperforms active investing over the long-term, we all seem to contain the gene that propels us toward active investing in varying degrees. If the stock-picking bee has its stinger in you, limit the pain to no more than 10% to 15% of the total portfolio. Even then, take extreme care in the selection of the individual stocks. As a Mosaic investor, tilt the portfolio toward passive investing through the use of non-managed ETFs.

Why fuss at all with a few individual stocks? Why not stick strictly with the passive approach and use non-managed ETFs for the total set of portfolio building materials? There is nothing wrong with that approach and it is one used with many portfolios tracked at ITA. However, for larger portfolios we do find we can bring down portfolio volatility or uncertainty by including a few highly selected stocks. In addition, projected return is frequently enhanced as is the portfolio diversity. It seems counterintuitive to think that adding a few individual stocks to the hundreds contained in the ETFs would make any difference. It does when the right stocks are included. The stocks are generally large-cap, well known, and produce a significant yield. These are very stable companies and this helps reduce portfolio uncertainty.

When conducting a QPP analysis we have several goals. One is to build a portfolio that has a high probability of outperforming our benchmarks. There are two primary benchmarks. One is the Vanguard Total Stock Market Index Fund, the VTSMX. VTSMX is preferred over the S&P 500 as it sets a higher bar. Further, the S&P 500 is not an appropriate benchmark for most portfolios as most portfolios are far more diversified than the limited S&P. The second benchmark is the customized ITA Index. The ITA Index, while slightly flawed, is a superior benchmark for portfolios that hold bonds, developed international markets, REITs, emerging markets, commodities, international REITs, etc. It makes absolutely no sense to measure a highly diversified portfolio against the limited S&P 500.

Investors interested in the Mosaic approach to investing can observe how the portfolio building blocks of ETFs and a few individual stocks are laid into place in an attempt to erect coherent portfolios. As with any structure, it first requires a plan. We call this the Strategic Asset Allocation plan and that "blueprint" is articulated in the Dashboard worksheet found within the TLH spreadsheet. Below is one such plan [click to enlarge].

The above screen shot shows several asset classes are outside the 25% threshold set in this portfolio. For example, small-cap blend is above target while the commodities asset class is below target. The 2.2% resting in the money market can be invested in the three under target asset classes and if that is insufficient, then it will be necessary to sell shares in the asset class that is above target. Not shown in this screen shot, but part of the TLH spreadsheet, are the calculations telling the user exactly how many shares of a particular ETF are needed to rebalance the portfolio.

For the beginning investor we recommend the passive approach to investing. Seasoned investors with the strong urge to pick a few stocks are welcome to use Mosaic methods as a reasonable approach to portfolio construction. Beware lest you slide into the active mode at your own peril.

Source: Using 'Mosaic' Methods as a Reasonable Approach to Portfolio Construction