Negative Compounding

The magical investment principle of compounding works both ways.

You have probably read articles about the wonderful effects of compounding when you invest consistently for many years. The original money plus yearly earnings forms a larger cash base each year. The bigger the base, the more dollars you earn from the same interest rate. 10% of $100 is $10. 10% of $1000 is $100. It is better to have $1000 invested at 10% than $100. See the story of two brothers for a full example of this.

The danger of investing in things that often lose value (stocks, bonds, commodities, etc...) is that negative compounding comes into play. If your portfolio loses 50% of its value due to severe recession, it takes a 100% gain to recover. $1000 becomes $500. Now you are only making interest on $500. It takes a gain of $500 (100 percent) in order to get back to $1000.

For this reason, it is very important to have a strategy to avoid huge losses in investing so negative compounding does not ruin your investment goals.  This is also why people are told to move money into more stable investments as they get older. 

Do you have a risk management strategy to avoid negative compounding?