Asset allocation is premised on the idea that different asset classes have different levels of risk, return, and volatility. By combining them in different ways, an investor can, to some extent, manage that risk while still generating returns.
Equities carry the highest risk as well as the highest return. Fixed-income investment (i.e., bonds and REITs) carry lower risk and moderate return. Cash carries no risk but a negative post-inflation return.
Two things generally influence how an investor chooses to allocate assets: his or her general risk tolerance, and the length of time he or she has until retirement.
Investors with a higher risk tolerance and/or a longer time horizon generally have a significant portion of their portfolio invested in equities. As they get closer to retirement, the proportion shifts more towards fixed-income investments. Every portfolio, however, has to be crafted for the needs and capacities of the individual investor.
Asset allocation is sometimes confused with diversification, which focuses on buying equities with substantially different characteristics.