Shanon’s Daemon : Profit from Randomness

There has always been confusion whether investors can reap benefits and make money even when the market is volatile. Well, you can earn high profits and earn in a volatile market based on the random price only you need assume that there will be a frictionless return. With few modifications even after the transaction costs, your investment can yield profit. This is based on the theory manifested by Claude Shannon. In the 1940s, the great genius conducted an experiment also known as Shannon’s Demon and it proved that it is possible to yield a profit from the random market conditions, but you need to make sure that it is volatile in nature.

Overview of the experiment

In this experiment, the portfolio of investment of a trader is divided into two parts. One part you have to invest in the stock and the other part will be in cash. The stock in which you need to invest needs to be highly jittery, each day either it needs to be double or half its value and every day in the noon, you need to rebalance your investment portfolio to another half and half split. After rebalancing for some time and after few trades your actual amount will yield maximum returns and profit.

The experiment is simple: Imagine a stock that is highly jittery and either doubled or halved in value every day. You then invest half of your portfolio in the stock, while the rest remains in cash. At noon each day you rebalance the portfolio back to a 50-50 even split. So, if you started with $1,000 and the stock got cut in half, the following day your portfolio would be $750 ($250 in the stock $500 in cash). After rebalancing, the portfolio would have $375 in stock and $375 in cash. As the chart below shows that after rebalancing only 72 times our $1,000 initial investment is now worth just under $100,000! That is not a bad chunk of change given that we didn’t have to do any stock forecasting to make this profit! In fact, had you bought and held this stock you would make zero profit. So we would require a very volatile asset to simulate this

Origin of the theory

The origin of this theory is based on the entropy concept that was coined by renowned physicist James Maxwell, who described the method of creation of motion machine with the help of the container where air is divided by partition to two chambers. In this partition a trapdoor is placed that is operated by a demon, who differentiates the air molecule based on their speed. Thus, the fast ones are segregated from the slow molecules. The fast ones can generate heat and useable energy is created from these random molecule movements. This random movement of molecules can be referred as volatility that can help you to earn high profit.

Use rebalancing techniques

You can compare the above mentioned experiment with trading activities. A trader need to allocate various costs as commission cost, work cost and the likewise. If you are wondering how this form of trading is effective, then you need to have an insight of the Constant Proportion Portfolio Rebalancing on which this methodology is based. The rebalancing techniques are also utilized here so that there is a constant parity between the weight of the cash and stocks as both are risky assets. As per the experiment of Shannon, you can take cash to maintain a neutral weight among the assets.

Yield hefty profits

Traders can exercise the experiment by the noted genius Shannon each day while trading so that they have a constant balance. If you are wondering the implications of the same in the real world, then considers the demon of the experiment to determine the randomness and its degree. If the Shannon portfolio is considered to be the optimum one, then the extension of the same can lead to randomness. In case, there is a variation in the algorithm suggested by Shannon, then you can use it to determine the strategies that are applicable.

So how much of your money you use to bet in your trades?