Predicting is difficult-especially about the future. So runs the old joke.

Difficult or not, though, predictions are necessary in the money game, and there's the rub.

It's tempting to think that a prudent approach to diversified investing relieves us of forecasting. Saying "no" to predictions is popular in financial planning circles, where the idea of peering into the future and then acting on the analysis is dismissed as market-timing. It's a reasonable view, but it's also a bit misleading.

Expecting to invest without forecasting is akin to planning a day of swimming and expecting you won't get wet. Every investment decision-or at least every reasonable investment decision-requires a forecast, an assumption, an expectation. The embedded bet on the future isn't always conspicuous, but it's there.

Asset allocation certainly isn't immune to this rule. Ultimately, there's a forecast behind every decision on how much to hold of this or that asset class and how to design the mix generally. The only question is whether the forecast is based on reasonable expectations, and that's where things get tricky.

Take the popular plan of crafting a strategic asset allocation and sticking with it through thick and thin, supplementing it only with periodic rebalancing back to the initial asset weights. It's a sensible strategy on the surface, one that sidesteps market timing in favor of a dispassionate plan for picking up risk premiums, much as if they were lying on the ground like acorns, awaiting collection. Yet so-called static asset allocation strategies are rooted in forecasting. These forecasts are arguably flawed, but they are forecasts nonetheless.

The rationale for static asset allocations are long-run historical returns-for example, the U.S. stock market's annualized 10% total return for the past 80 years, which investors use as if it were a window looking into future performance. Even if that held true in the long run-a debatable proposition-there's reason to wonder if it will hold over, say, the next ten or even 20 years.

Returns, after all, are volatile in the short run, a fact that's too easily overlooked when we rely on long-run history as a guide. Even the rolling-ten-year return for U.S. stocks has been something of a roller-coaster ride, ranging from an annualized 3% to nearly 18%. Waiting for salvation in the long run is a nice idea on paper, but as Keynes said, in the long run we're all dead. In the short term, meanwhile, stuff happens, as the current climate so painfully reminds.

The lesson is that the future looks different, sometimes radically different, depending on from where you are looking. If you ignore this fact while crafting your asset allocation, you're asking for trouble-for instance, if you built your plan in early 2008 while looking only at long-run historical results. Obviously, that design would be something less than optimal now.

Risk premiums appear to be stable over very long periods of time, but that's mostly an illusion if we adjust for the real-world time horizons of clients. In fact, these premiums vary through time, as a large and growing body of academic research and real-world evidence tell us. The only question is how best to manage money in a world where the premiums fluctuate. The basic answer is that investors shouldn't rely totally on static asset allocation strategies.

Consider the outcomes delivered by a diversified group of asset classes in the period from 2000 to 2002 and compare those with the dramatically different outcomes in 2008. Last year, stocks, corporate bonds, REITs and commodities suffered steep losses. Only government bonds bucked the trend with positive returns. But the previous bear market was a different animal entirely. Although stocks took a beating from 2000 to 2002, bonds, commodities and REITs posted handsome gains. Why the difference? Valuation was one reason, and arguably the dominant reason.

Consider that the U.S. stock market peaked in March 2000. At that point, yields on REITs traded at an enticing 8.3%, or well above the 6.3% for the benchmark 10-year Treasury note at the time. By contrast, U.S. stocks at the time posted a paltry trailing yield of less than 1.2%, based on monthly data for the S&P Composite-an all-time low. Over the course of the next three years, REITs rose nearly 44%, while U.S. stocks retreated by 40%.

There was no repeat performance last year, of course, when REITs tumbled 39%, exceeding even the steep 37% loss for U.S. stocks. Why the difference? Valuation once again appears to offer a clue. At the last peak for stocks in October 2007, the REIT yield was 4.2%-slightly below the 10-year Treasury's 4.5%. Was there a compelling case to buy REITs when a risk-free Treasury note offered a higher yield? Apparently not. REITs looked compelling in early 2000, but they seemed overpriced in late 2007. Then again, saying as much at the time was tantamount to being labeled a market timer.

Labels aside, ignoring the price of risk isn't a strategy; it's denial. Even worse, it courts trouble when you're managing asset allocation. It's easy to say that market timing is a loser's game, but the truth is that it's naïve to compare market timing with adjusting asset allocation based on the expected price of risk.

"What is crucial to the success of diversification is the price you pay for initiating exposure to different asset classes," says Adrian Cronje, director of asset allocation at Wilmington Trust. "At certain times, you're paid to assume risk; at other times you're not paid to assume risk."