Thread by @TaylorPearsonMe

1/ Claude Shannon, the developer of information theory, was also an exceptional investor, averaging 28% annually in his lifetime.

He was able to do that in large part because of a key insight he had called Shannon's Demon.

Here's how it works:

2/ He developed an investment strategy for a portfolio that was 50% in a stock whose price moves in a completely random manner (a “random walk”) with an expected return of 0 and 50% cash.

The portfolio is then rebalanced daily back to the original 50/50 allocation.

3/ Despite both pieces of the portfolio having a return of zero at the end of the simulation, the rebalanced portfolio had a positive return.

4/ In Shannon’s simulation, the stock is highly volatile. On any given day it can either double in price or drop by 50%. This is unrealistic in the real world, but makes it easier to demonstrate the fundamental point which does, in fact, hold.

5/ Here’s another simulation using two stocks, both with a positive expected return and rebalancing between them.

6/ Most interestingly, rebalancing between two uncorrelated stocks, each with a negative expected return, can produce a positive return.

7/ This only works because the two stocks are uncorrelated. By starting with a diversified portfolio and rebalancing between the two uncorrelated assets, an investor is systematically buying low and selling high.

8/ From a practical standpoint, there is probably an advantage to rebalancing with a lower frequency not captured in these simulations.

9/Every time an investor rebalances, there will be commissions, taxes, and other transaction costs so the assets being rebalanced must have diverged sufficiently to merit the rebalancing

10/ Also important to note, the less correlated the assets, the greater the rebalancing premium. If you have two perfectly correlated assets, there is no rebalancing premium at all.

11/ Yet, the fundamental point stands, you can harvest volatility between uncorrelated assets to create a rebalancing premium.