Asset Allocation describes how your investments are spread across different investment categories - like stocks, bonds, international, real estate and cash. Determining and balancing how much of each category belongs in your portfolio and how often you should rebalance back to your desired mix of investments is a key element of investment management.
If you are willing and able to take more risk, you should have more money allocated to risky investment choices and if you desire and need to take less risk, you should have more money allocated to less risky choices. In general:
Asset Allocation and periodic rebalancing is putting diversification, risk management and correlation into practice. Many professionals use historical asset allocation information as a guide, but also combine that information with existing capital market expectations, diversification strategies, risk management strategies, risk and return analysis, correlation analysis, independent research and professional judgement to build portfolios.
Searching the internet, you will find everything from simple "rules of thumb" for asset allocation to highly complex models allocating across dozens of asset categories and subcategories. There is no one right answer to asset allocation and it can vary greatly across individuals depending on their risk profile and investment horizon.
A very basic asset allocation may look at three categories: Equities/Stocks, Fixed Income/Bonds and Cash/CDs and then establish an investment range for each category.
Many sites and advisors use a tool or questionnaire as the first step to determine your ability and willingness to take risk. Once you have your risk profile determined you can work on building the portfolio that most closely matches your risk tolerance, making actual security selections for each category (i.e. exactly what bonds and exactly what stocks will you invest in)
You may decide or your advisor may also recommend alternative asset classes to stocks and bonds such as real estate, commodities or other alternative investments.
Just like we don't know ahead of time what the performance or risk of any asset or portfolio will be, we don't know in advance what allocation will generate the best returns or offer the lowest risk. Since asset prices will go up and down in value, we also don't know how long it may take before the portfolio becomes unbalanced and ends up more or less risky than intended. Portfolios need to be periodically rebalanced to bring them back in line with the desired targets or if the risk profile of the individual changes.
Depending on the type of account you are rebalancing, there may be tax consequences of the buying and selling associated with rebalancing. So when determining when and how often to rebalance, one must consider the potential tax liability, with the change in portfolio risk due to market movements, with the analysis of where markets may head next to determine when rebalancing is most warranted.
Here is a selection of books that explore the topic of asset allocation in more detail.