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Shannon's Demon, Parrando's Paradox

Sharat
7-8 minutes

I have been thinking of forming a good portfolio and a way to

measure the success of my portfolio over time. The question was to
arrive at a portfolio allocation scheme not exactly based on my
guesswork but a slightly analytic scheme. My search for these
brought me in touch with a demon and a paradox. Let us take these
baby steps for starting to create a portfolio.
Shannon’s Demon: Making Money out of thin air.
Claude Shannon is very well known among electronics engineers
for the ground-breaking work done by him in the area of Information
Theory. But very few people know of his real expertise in stock
market investing. The book “Fortune’s Formula”1 by William
Poundstone captures his amazing work and his contributions to the
field of investments. In the book, Shannon told an audience of a
method to “Making Money from Air” especially if has completely
random behavior and is volatile. This case study has been dubbed
Shannon’s Demon.
Shannon’s Demon is a simple problem. Let us assume you have
two assets A and B. Assume asset A works by flipping a coin. If
“head” occurs, we get +100% or -50% in the case of “tails”. Asset B
gives no return is cash independent of the toss outcome. Suppose
Asset A has starting NAV of 1$. Suppose you had heads on the first
toss, NAV would go to 1 *(1+100%) = 2.0. Subsequent “tails” would
take your NAV to 2.0 *(1-50%) ~ 1.0. Note that just a 50% fall can
negate a +100% move. We discussed here that what investors get
is geometric mean and not arithmetic. So, while the arithmetic
return is positive, the geometric return is zero. If you get an equal
number of heads and tails (fair coin), Asset A should give you long-
term returns same as Asset B that are no growth/returns.
But Shannon proposed an idea to make money grow despite the
said conditions. He suggests that you invest 50% in each of the
assets and after the very toss, “re-balance to 50%”. Let us take an
example.
Initial NAV: 1 (50%A, 50%B = 0.5 each)
Toss 1(H): A = 0.5*(1+100%) = 1.0, B = 0.5. Total NAV = 1.50. Re-
balance to 50% after round of winning/losing. This implies A = 0.75,
B= 0.75
Toss2(T): A = 0.75*(1-50%) ~ 0.375, B = 0.75. Total NAV ~ 1.125.
This is greater than 1.0, our initial capital and that means a growth
of 12.5 % after 2 turns.
So, we really did create money out of thin air in two-coin flips by the
process of re-balancing compared to the original exercise. It must
be intuitive that we will get an equal number of heads and tails
eventually, and our long-term returns will be more for each pair of
Heads and Tails suggesting growth in the portfolio. I created an
example case in excel and I show below the same. Note that initial
lower allocation to Asset A would make the strategy look bad but
eventually, reality catches up and Asset A reaches its “destined”
value whereas Shannon’s portfolio keeps chugging along. Notice
also that the moves are less rugged indicating a possible “lower
volatility.”

I would suggest readers even try it out at home and confirm that is
indeed the case.
Eugene Fama and a bunch of folks propounded the EMH
hypothesis which said that stocks’ daily movement is mostly a
random walk, and most people cannot make money through the
stocks as their prices reflect everything known to the world. But, as
seen above, Shannon showed that even if markets are efficient,
you can use the underlying volatility to make money through a
process of diversification and rebalancing.
Parrando’s Paradox: In 1996, Juan Parrando proposed another
surprising experiment (“Parrando’s Paradox”) that showed another
facet of investments and re-balancing. In this paradox, two “loser”
assets provide higher returns by simply mixing and re-balancing
them at every opportunity possible. An example is below2:

Let us take the case of a fair coin and look at the returns of Asset 1
(A1) and Asset 2 (A1) after one set of heads and tails.
Asset 1: Starting: 1.0 ==> Heads ==> 1 * (1+40%) = 1.4 ==> Tails
==>1.4*(1-30%) =0.98. This is a loss of 2% from a starting amount
of 1.0
Asset 2: Starting: 1.0 ==>Heads ==> 1 * (1-20%) = 0.8 ==> Tails
==>0.8*(1+15%) =0.92. This is a loss of 8% from a starting amount
of 1.0
Individually, both assets are horrible money losers along with high
volatility in return streams. If you invest in them, you will eventually
lose your entire capital.
Parrando’s Paradox follows Shannon’s demon thought process and
does a 50% allocation to each asset and rebalances after every
iteration. Let us see what happens after 1 set of iterations of Heads
and Tails.
Starting: 1.0, 50% A1, 50% A2 ==> A1 = 0.5, A2 = 0.5
Heads ==> A1 = 0.5 *(1+40%) = 0.7, A2 = 0.5*(1-20%) = 0.4. Total
NAV = 1.1. Rebalance back to 50-50 means A1 = 0.55 and A2 =
0.55
Tails ==> 0.55 * (1-30%) = 0.385, A2 = 0.55 * (1+15%) = 0.6325.
Total NAV = 1.0175. This is a 1.75% increase in NAV from starting
point. This observation of taking two losing assets and a process of
rebalancing providing higher returns had stumped people. It has
been a “paradox” since his discovery. I provide an example in excel
to show the same.

If we look at the assets carefully, we may realize that it may not be

paradoxical after all. On a head, A1 provides positive returns
whereas A2 provides negative returns. On the other hand, A2
provides positive returns on Tails but A1 provides negative returns.
This insight gives way to a “hedging” strategy. The key is to
rebalance as well. If you do not rebalance, assuming a 50%
allocation to each asset, you will still lose money.
Other thoughts
I hope the above tells you that there is more to investments than
selecting the right stocks or mutual funds. Also, do not have fixed
opinions on any asset class or individual assets. Being open to the
possibility to make money through a combination process is more
helpful. I keep hearing opinions that gold is a useless asset or real
estate makes no money or for that matter, stocks are all about
gambling, and off late opinions on cryptos are developing on either
side. I would urge readers to accept all forms of investments,
understand their underlying risks/benefits, and look at portfolios
holistically. Do not summarily reject any asset/asset class. This
ability to be to possibilities can help us, individual investors, to look
for growth in wealth.
Summary
Shannon proved that assets with high volatility, by a process of
rebalancing, provide for better outcomes to portfolios. Assets with
differences in behavior provide for a strategy to grow wealth.
Through these perceived paradoxes, we start our journey of
portfolio creation.