Asset class allocation can be looked at as an enormous board game with about 25 buckets that hold money.  There are trillions of dollars in all the fo the financial markets, and all of this money is spread between these buckets.  The buckets all stay on the board at all times, and over a trillion dollars gets shuffled between the buckets on a normal day.

For example, if tech stocks go down 10% in a day, it's because more people wanted to sell tech stocks then wanted to buy them that day.  These sellers got money when they sold and if they didn't buy any other kinds of investments, this money just went into the cash, or money market, bucket.  Over the next few days this money finds its way into other buckets because investors don't like to hold cash and earn only 2% - 4% for very long.  Which buckets it oges into are mostly determined by news and market timing decisions of short-term traders.

One of the main points of asset allocation is to hold a little bit of every major bucket this cash is likely to go into.  This way, no matter where the money goes, you're already there.  This eliminates the need for market timing because you already own a piece of every major asset class all the time.

For example, if $10 billion worth of tech stocks were sold in a day, then this $10 billion has to go somewhere - cash, bonds, real estate, large-cap value stocks, etc.  If you consistently own a little bit of everything, then it's hard to lose a lot of money long-term because it all has to stay on the board in one bucket or another.  It's just a question of which bucket it will be shuffled to next and when.  Since nobody knows which bucket or when for sure, it's best to just hold a little bit of most of them.

It's rare for all major asset classes to be down at teh same time for very long.  So when a well-allocated portfolio is down, it desn't stay down for very long.  Because if a lot of markets are down at the same time everyone is hiding in cash, or money markets.  Investors don't like earning 2% - 4% for very long, so they are waiting to pounce and put this money to work somewhere.  When they pounce there is usually a big, sudden rally in at least one major asset class.  That's why the best time to invest is when everything is down at the same time.

By playing the asset class allocation game this way, instead of guessing which bucket will do best in the short-term you eliminate the risk of not owning the right bucket at the right time.  Over the long-run this provides the highest returns with the least amount of risk.


For another description of asset class allocation check-out Your Portfolio Pie.

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