An index mutual fund invests in the stocks of a stock index, such as Standard and Poor's 500, the Russell 2000 or the Wilshire 5000. An index tracks the performance of a set of stocks index managers deem important indicators of the direction of the stock market. You can put your money in a mutual fund that buys the stocks of an index. Timing your purchase requires both knowledge and instinct.
To decide when to invest, you should know about Dow Theory. First devised by Charles Dow and refined by S.A. Nelson and William Hamilton, this theory helps you understand stock market trends. One of the first lessons of Dow Theory is that stock market averages take all economic trends into account and price those trends into stocks. In fact, the stock market tends to anticipate economic trends by as much as six months. One way you can decide when to buy an index fund is to interpret stock market swings. A sharp and prolonged uptick could mean the economy will improve in the next six months. A sharp decline may foretell a dwindling economy six months from now. However, that doesn't mean every up or down move has significance.
A primary movement, or trend, lasts for several months or years. This type of movement lifts most stocks or sinks most stocks, and will continue until some event intervenes to disrupt it. You will find much debate among investors about which direction the primary movement is headed at any given time. You have a better chance of identifying primary movements if you look at stock index charts that span several years. You will see insignificant ups and downs as the index moves in an overall up or down direction. Two prime times to buy an index fund are when a primary down trend ends or when an upward primary trend establishes itself. You must decide if the trend looks favorable based on historic patterns in the chart of the index. For example, if you see a long downtrend that reverses for several months and begins climbing, you may decide you are witnessing a reversal in the primary trend. Your perception of trends and your instincts about the economy guide you through this decision.
Secondary movements go in the opposite direction of the primary movement. Think of it this way: all of the investors who aren't convinced about the direction of the primary trend make a bet that the primary trend isn't real. For example, a rise in stocks for several months may be met by a flurry of selling as some investors think the stock rise in unreliable. Some investors consider a secondary movement an opportunity. If you think the primary movement is up, and you see a pullback in the market, you could buy an index fund at that point and take advantage of cheaper stock prices before the market resumes its upward movement. You can spot secondary movements by examining the up and down movements on the chart of a primary trend. The see-saw appearance of stock charts results from secondary movements and recovery from those movements.
When you buy index funds, you become a long-term investor, because buying and selling frequently doesn't give the large fund of stocks time to move in a single direction for long. The idea of buying a mutual fund is to stick with it until you see a reversal in the primary movement. For that reason, daily price moves in the stock market should not influence your buying decisions. Focus on your own understanding of the primary movement and base your fund-purchasing decisions on that.
Kevin Johnston writes for Ameriprise Financial, the Rutgers University MBA Program and Evan Carmichael. He has written about business, marketing, finance, sales and investing for publications such as "The New York Daily News," "Business Age" and "Nation's Business." He is an instructional designer with credits for companies such as ADP, Standard and Poor's and Bank of America.