Invest With A Demon

I’ve long been an advocate of diversification among disparate asset classes. This typically means setting allocation targets to each and periodically rebalancing. The most obvious reason for this is risk reduction. But it can also boost returns.

This idea can be traced to the research of one Claude Shannon, a mathematician and engineer at Bell Labs in the 1950s, often credited as the father of information theory. He described a principle sometimes colorfully described as “Shannon’s Demon”, perhaps since it almost appears to produce something from nothing. But as we will see, there are no evil spirits involved. Instead it forms the foundation of a diversify and rebalance approach to investing. It’s embodied in the Permanent Portfolio of Harry Browne we discuss in Investing Basics and in the model portfolios patterned after it. Here we’ll take a look under the hood and see what makes it tick.

Let’s say you have two assets with a zero long term return. Let’s assume they have an annual correlation of -1. Asset A returns 10% in odd years and -9.0909…% in even years.  Asset B returns -10% in odd years and 11.11…% in even years. You put $100 dollars into each asset. Here what your balances look like over time:

Asset A      Asset B

$100          $100

$110            $90

$100          $100

$110            $90

You’ve obviously reduced your volatility and risk to zero. Benefit one. But returnwise, it looks like you’re going nowhere, right?

Right. But what if you rebalance every year?  At the end of Year 1 you shift $10 from Asset A to Asset B. Then at the end of Year 2 you will have more than the $200 you started with.

Asset A      Asset B

$100          $100

$110          $90    ->   $100       $100

$90.90      $111.11 -> $101.01   101.01

 

If you continue this process the earnings will compound so that your returns will be positive. This strategy produces a positive combined return from two assets that have zero intrinsic return.

Sound too good to be true? It’s been said that diversification is the only free lunch in investing. Here is mathematical proof.

Of course this is a highly artificial and contrived example, simplified to illustrate the concept. The important point is that properly combining assets can produce returns beyond any of the individual assets. Diversify and rebalance.

What may not be so obvious from this simple example is that this result does not depend on predictability of the return patterns. A similar result is achieved if the long term returns are composed of a random sequence of short term returns. The total return of a two asset portfolio can exceed the return of either one. The only requirement is that in the vicinity of your rebalancing interval the returns have correlations less than 1.

Expand this principle to multiple assets and the results improve. The benefits of diversification are real, and to paraphrase Teri Hatcher a la Jerry Seinfeld, they’re spectacular. Not only does it reduce risk but it can also improve returns.

The core point is that a good portfolio is not merely a collection of good assets … the way they work together is gestalt thing.

It’s math. But is it just mathematical trickery? Or is there some real economic foundation to it?  

There is. We just examined it on a mathematical level, but can it be looked at on another level altogether … the human level.  You can profit from investing the same way you can in any other situation – by providing a service to your fellow man. The rebalancing process is a systematic buy low sell high strategy. Low prices signify that others want to sell. You’re providing a service by stepping up to buy. High prices signify that others want to buy. You’re obliging them by selling. This – providing a service valued by others – is the ultimate source of your excess returns.

By diversifying, you’re maintaining a broad inventory of assets for this purpose, ensuring you always have something that somebody wants, expanding your opportunities to serve your fellow man. 

And to get paid for it too.

3 thoughts on “Invest With A Demon

  1. Finster says:

    Cue Meta: “Gold getting killed!”

    I’ve previously identified $2400 as an important resistance level for gold, and traders having piled in on the momentum that carried it there are deserting. The media narrative holds that it’s the fear premium coming out on relief the Israel-Iran skirmish hasn’t erupted into full on war. There’s no doubt some truth in that, but it’s not the whole truth, or it would have been impossible to call on April 3 when gold was still trading in the $2200s.

    Traders might be selling, but investors are buying. The fundamental force behind rising gold prices hasn’t gone away. US federal debt is still exploding and politicians are finding new ways to explode it faster on a practically daily basis. This is having the reasonable effect of trashing Treasury prices. But as yields rise and the interest payments on the federal debt feed back into the debt itself, the Fed will come under pressure to tamp down on yields.

    This would not be unlike pushing in on a bump in a water balloon. It will just pop out somewhere else. In this case, it will transmogrify plunging bond values into plunging dollar values. You can’t make the Treasuries worth any more; the best you can do is support their prices by making dollars worth less.

    This means that even if gold just sits there and does nothing, it will take more dollars to buy it.

    This will support gold prices for the foreseeable future.

    We can generalize on that. Any tangible form of money that can’t be inflated will benefit, whether gold, silver, platinum or copper. Any tangible necessity will, including oil, coal, gas, food and shelter. For a five year or more time frame, you could say I’m bullish on just about everything but currencies, bonds denominated in those currencies, and bubble assets, loosely defined as just about anything the popular financial media are excited about.

    How we get there has yet to be determined, but it’s plausible that some event or crisis, likely accompanied by a major selloff in stocks, will prompt another round of federal “stimulus”. But this time the stimulus will have never stopped, and this stimulus on stimulus will push fears of fiscal disaster over the edge. It will most likely come about in the same way that an Ernest Hemingway character went broke in The Sun Also Rises:

    “Gradually, then suddenly.”

  2. jk says:

    i agree wholeheartedly. i would just caution people to be careful when someone talks about the value of the dollar. there’s the dollar vs other fiat currency, where the dollar is lately quite strong. but all fiat is deteriorating in value vs stuff of all kinds; that’s inflation. so be careful to distinguish the value of the dollar vs other fiat, and the value of the dollar vs stuff.

    1. Finster says:

      Thanks for the clarification, JK. When discussing this kind of issue, I often include a comment to that effect, that the term “the dollar” is conventionally used in a specific forex context whereas I’m speaking generally.

      It makes a big difference. Because most countries don’t like to see their currencies appreciate greatly relative to others, when one depreciates its currency, the others tend to follow, especially when it’s a big importer and reserve currency like the US. It’s like lemmings following each other over the cliff. I just don’t mention it every time because the diversion can get in the way and make a simple point sound complicated. You just patched up that little shortcut here.

Leave a Reply

Your email address will not be published. Required fields are marked *