Asset allocation is a strategy, advocated by modern portfolio theory, for reducing risk in your investment portfolio in order to maximize return. Specifically, asset allocation means dividing your assets among different broad categories of investments, called asset classes. Stocks, bonds and cash are examples of asset classes, as are real estate and derivatives such as options and futures contracts.
Most financial services firms suggest particular asset allocations for specific groups of clients and fine-tune those allocations for individual investors. The asset allocation model - specifically the percentages of your investment principal allocated to each investment category you're using - that's appropriate for you at any given time depends on many factors, such as the goals you're investing to achieve, how much time you have to invest, your tolerance for risk, the direction of interest rates, and the market outlook.
Ideally, you adjust or rebalance your portfolio from time to time to bring the allocation back in line with the model you've selected. Or, you might realign your model as your financial goals, your time frame, or the market situation changes.