Asset allocation means diversifying among different classes of financial assets. Sometimes investors think of this as just dividing their money between stocks, bonds and cash. But true asset allocation goes much further.

Within the category of stocks, there are large-caps and small-caps, foreign and domestic, growth and value, etc. Then, within the bond category, there are governments and corporates, high-grade and high-yield, inflation-adjusted treasuries, mortgage bonds, etc. And the beauty of asset allocation is that it allows you to take these non-correlated assets (assets that don't move in tandem) and combine them in such a way that you maximize your returns while minimizing risk.