Claude Shannon (1916–2001), the father of information theory, proposed a deceptively simple thought experiment in the 1960s: Can you make money from a stock that has zero expected return?
The answer, which shocked many mathematicians, was yes — through the simple act of rebalancing. Shannon's Demon is not magic, not arbitrage, and not prediction. It is the compounding benefit of repeatedly selling high and buying low, enforced mechanically by maintaining a fixed allocation.
Year 2 (Down −50%): Stock halves → Buy some stock, restore 50/50 split
Result: You sold stock at a high price and bought it back at a low price.
The portfolio grew. The stock went nowhere.
The key is the asymmetry between arithmetic and geometric returns. A stock that goes +100% and then −50% has an arithmetic average return of +25% per year — yet its geometric (actual compounded) return is 0%.
Rebalancing captures the arithmetic mean while diversification prevents you from suffering the geometric mean of a single volatile asset. This "gap" between arithmetic and geometric returns is called the volatility drag — and rebalancing harvests it.
- 1Set your starting portfolio and the number of years to simulate.
- 2Configure Asset A (the volatile stock): how much does it gain in an up year and lose in a down year? The default (+100%/−50%) is the classic Shannon's Demon setup — zero net return for the stock itself.
- 3Configure Asset B (stable cash): you can set it to 0% for a pure demonstration, or add a small return (like 4–6%) to simulate a liquid fund or FD.
- 4Choose the target split — 50/50 is optimal in the pure Shannon case, but you can experiment. Try 60/40 or 70/30 and observe the difference.
- 5Select a simulation mode: Fixed sequence, random coin flip, or worst-case (down first). Run multiple times in random mode to see statistical patterns emerge.
- 6Press Run Simulation and compare the rebalanced portfolio vs buy-and-hold. Watch the rebalancing bonus and individual events in the log.
Shannon's Demon is an idealized concept. In real markets, several factors reduce the bonus:
Indian equity markets (Nifty 50) have historically delivered about 12% CAGR with ~22% annual volatility. Debt (gilt/short-duration funds) deliver ~7% with ~5% volatility. Gold delivers ~9% with ~18% volatility.
A classic 60/40 Equity-Debt portfolio rebalanced annually has historically outperformed a static drift portfolio by 0.5–1.5% per year in Indian markets — this is the rebalancing bonus in practice. Small numbers compound into enormous differences over 20–30 year horizons.
The simulator uses these Indian market assumptions (12%/22% for equity, 7%/5% for debt) in its Monte Carlo random mode, so your results reflect realistic Indian market behaviour.