Shannon’s Demon: How to Create Money Out of Thin Air (The Rebalancing Bonus)
Shannon’s Demon: How to Create Money Out of Thin Air (The Rebalancing Bonus)
EXECUTIVE SUMMARY
- The Experiment: Claude Shannon (father of Information Theory) proved mathematically that you can make money even if the market goes nowhere. He imagined a stock that doubles one year and drops 50% the next (Geometric Return = 0%).
- The Demon: By rebalancing 50% Cash and 50% Stock every year, the portfolio grows despite the underlying stock having zero long-term return. This excess growth is called the “Rebalancing Bonus.”
- The Lesson: Volatility is not just risk; it is fuel. If you harness volatility through systematic rebalancing between uncorrelated assets, you generate “Shannon’s Demon”โprofit from chaos.
Most investors hate volatility. They want a smooth line up. But to a mathematician, volatility is energy. Shannon’s Demon is the proof that “Buy Low, Sell High” is not just a sloganโit is a geometric necessity. According to Team BMT Analysis, this is the hidden engine behind successful asset allocation strategies like Risk Parity (#410). Without rebalancing, you are leaving free money on the table. Source: Fortune’s Formula (William Poundstone)
Scenario: Stock A starts at $100. Year 1: +100% ($200). Year 2: -50% ($100). Net Return: 0%.
- Buy & Hold Investor:
Start $100 -> $200 -> $100.
Final Wealth: $100. (Zero Gain). - Shannon Rebalancer (50% Stock / 50% Cash):
Year 1: Portfolio hits $150 (Stock $100 + Cash $50). Rebalance to $75/$75.
Year 2: Stock drops 50% ($75 -> $37.50). Cash stays $75.
Final Wealth: $112.50.
Result: You made 12.5% profit while the market was flat.
Volatility Harvesting Potential
| Asset Correlation | Rebalancing Bonus (Est) |
|---|---|
| High Correlation (US vs. Europe) | 0.2 |
| Zero Correlation (Stocks vs. Cash) | 1.5 |
| Negative Correlation (Stocks vs. Trend) | 2.5 |
*Chart Note: The more uncorrelated (or volatile) the assets are, the larger the “Bonus.” This is why mixing Stocks with Crypto or Managed Futures is so powerful.
CRITICAL SCENARIO: The “Crypto” Application
Where volatility is highest.
| Strategy | Bitcoin Performance | Portfolio Outcome |
|---|---|---|
| HODL (Buy & Hold) | -80% Crash | -80% Loss (Painful) |
| Shannon’s Demon (50/50 BTC/USD) | -80% Crash | -40% Loss (Reduced Drawdown) + Buying Power for recovery. |
Execution Protocol
The demon feeds on “non-correlation.” Good pairs:
Stocks + Long Volatility (Options).
Stocks + Managed Futures.
Tech Stocks + Energy Stocks (often move opposite).
Do not rebalance every day (taxes/fees kill the bonus). Use “Tolerance Bands.”
Rule: If target is 50%, only rebalance if it hits 40% or 60%. This captures the big moves while ignoring the noise.
Selling winners generates capital gains tax. This friction destroys the Rebalancing Bonus. Execute Shannon’s strategy inside an IRA or 401(k) where trading is tax-free.
Fail Condition: Doing high-frequency rebalancing in a taxable account. You are just making the IRS rich.
WEALTH STRATEGY DIRECTIVE
- Do This: Rebalance your portfolio annually or when bands are breached. It is the only guaranteed way to increase geometric returns without increasing risk.
- Avoid This: Letting winners ride forever. Letting winners run” works in Momentum investing, but for Asset Allocation, it kills the diversification benefit. You must prune the tree to grow the forest.
Frequently Asked Questions
Is this just “Buy Low, Sell High”?
Yes, but systematized. Most people try to buy low based on feelings (which fails). Shannon’s Demon buys low based on mathematical weights, which forces discipline.
Does it work in a Bull Market?
In a straight-line bull market (e.g., S&P 500 in 2017), rebalancing hurts returns because you keep selling the winner. Shannon’s Demon shines in volatile, choppy, or mean-reverting markets.
What is Geometric Return?
It is the real compound return you eat. If you lose 50%, you need a 100% gain to get back to even. The Arithmetic average is +25%, but the Geometric average is 0%. The Demon optimizes the Geometric return.