Asset allocation describes how your capital is distributed to the diversity of asset classes you have chosen to hold in your portfolio, i.e., your investment universe. If you had chosen full worldwide diversification, your next step would be to determine how to allocate your capital across that aggregation of asset classes. One possibility would be to hold what's known as the Market Portfolio. To do this you would have to invest in all those asset classes on a market capitalization-weighted basis. That would by definition be an efficient portfolio and constructing such a portfolio is possible with index funds. It's also possible with regular mutual funds, but getting and maintaining the appropriate weightings would be pretty tricky and require a lot of time and effort.

Beyond the Market Portfolio, there are just about as many ways to select asset classes and allocate capital as there are portfolio managers, investment advisors and newsletter editors. Although they're mostly based on the same financial theories, everyone has their own model and their own forecasts to fuel their models. But going any deeper into asset allocation would diverge too far from the topic of this article...diversification.

In real estate it's location, location, location. In investing it's diversification, diversification, diversification. You must be adequately diversified, otherwise you will be exposed to too much risk with respect to your expected return. And no asset allocation model can compensate for under-diversification, as your chosen degree of diversification defines the investment universe across which asset allocation must take place. With thousands of mutual funds to choose from, there's no good reason for anyone to be under-diversified.

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