Asset allocation is to reduce your risk by diversifying into different classes of assets. Its akin to not putting all your eggs in one basket. As your investment returns are dependent on your risk, it is hoped that with diversification you will spread your risk and get to match your targeted returns. To reduce the risk its best to hold different major classes of asset such as cash, bond, stock and real estate including foreign asset holdings. However the difficult part is in deciding what ratio to hold in each class of asset. There is no simple formula that can find the right asset allocation for every individual but it does need to take note of your risk profile and time horizon.
Chart from http://www.goodfinancialcents.com/
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