Credit: behaviorgap.com

In my previous article, “The perils of chasing hot fund managers,” I showed that the average investor in a mutual fund run by “star” manager Bill Miller would be better off buying and holding an S&P 500 index fund.

There is only one problem. Most index fund investors are not immune to the buy high and sell low tendency, as illustrated by the table below. Between 1991 and 2005, the Vanguard S&P 500 Index Fund (VFINX) returned an annualized 11.51%, but the average VFINX investor only earned a return of 7.96% during the same period.

This begs the question: Is there any hope that an investor could capture the full return of a fund? My answer is affirmative. In fact, I have helped my clients capture roughly 106% of fund returns! The key to achieving that is to have an effective mechanism to counter the tendency to buy high and sell low.

1. Spend time to draft an investment plan. The process of drafting an investment plan is a pre-commitment device. With a written plan, you are much more likely to stick with it when the going gets rough.

2. Have a target allocation. This is a device to enforce a buy low and sell high plan, the opposite of our natural tendency.

3. Extend your perspective. In August and September, when investors were captivated by the daily market swings of 5+% up or down, I sent communications to my clients showing them historical statistics of the last 5, 10, and 20 years. Historical perspective is much more informative than daily market swings. So develop a long-term perspective.

4. Reset the frame. When the market dropped in a very short period of time this summer, you could see this as a loss of wealth, or you could see it as a buying opportunity. Different framing leads to different action. Seeing a market drop as a buying opportunity is a much more productive frame for your long-term wealth .

If you can do the above four, you will be able to harness your emotions and greatly increase the odds of capturing all that the market can give you.