Was reading the book ‘Fortune’s Formula’, which I highly recommend. Claude Shannon, the genius of Information theory fame, came up with an approach to investing in the market using a interesting variant of Kelly’s betting approach.
Assuming a market with constant mean (no drift / trend over time):
- Invest 1/2 of your capital in an asset
- Periodically rebalance
- If the market went up, sell enough units of the asset to have exactly 1/2 of your capital invested
- If the market goes down, buy enough units of the asset to maintain 1/2 investment
This is an effective scheme (assuming no transaction costs). Why?
- rebalancing implicitly executes a mean reversion strategy
- losses reduce the capital in the market
- wins increase the capital in the market
In effect, this is a ratcheting investment approach. As was pointed out, most assets are not constant mean over time. This would imply a strategy that trades mean reversion around a longer term drift in the mean. How might such a strategy work?
- since drift might be upwards or downwards, fundamental position should be long or short
- rebalancing should take into account the expected movement of the mean so that the ratio of cash to position will depend on this
This is referred to as a Constant Rebalanced Portfolio (CRP). Thomas Covers, later extended on this concept with non-even distribution of allocations with his Constant Universal Portfolio (CUP).