Beyond risk control, rebalancing can occasionally add return outright — an effect captured by Shannon’s Demon, named for the information theorist Claude Shannon.
The Coin-Flip Game Picture an asset with zero long-term return: each period a coin flip either gains you 50% or loses you 33.3%. Its arithmetic return looks positive — — but the geometric return, the one that actually compounds, is
The gap is volatility drag: compounding punishes variability, and CAGR is well approximated by . Here a 42% volatility exactly consumes the 8.35% arithmetic return: .
The Demon Now hold only half your capital in the coin and half in cash, rebalancing back to 50/50 after every flip. Both the average return and the volatility halve — to 4.175% and 21% — but because drag falls with the square of volatility, the geometric return turns positive: . Rebalancing manufactured a 2% compound return from two assets that each compound at zero. That is the rebalancing bonus.
The bonus is real but conditional. As Michael Kitces and William Bernstein point out, it is largest precisely when the coin-flip conditions hold: the assets earn similar long-run returns, are highly volatile, and are negatively correlated. Real stock/bond portfolios meet those conditions only weakly. In practice rebalancing usually slightly lowers long-run return relative to letting equities run, because you are systematically trimming the higher-returning asset. You rebalance to control risk; the occasional bonus is a side effect, not the reason.