Think of asset allocation as a way of reducing your risk by not putting all your eggs in one basket. Imagine if you put your entire nest egg in a single stock like Enron. When that one stock plummets, you lose nearly everything. More generally, think what might have happened if you owned nothing but Technology stocks at the end of the bubble. This time you may have owned dozens of stock, but you likely lost a substantial portion of your investments. Asset allocation is a way to spread risk by not putting money in only one kind of investment. You invest in different asset classes. This could mean buying stocks of companies that are different sizes, industries and countries, while also putting money into bonds, money markets and even real estate.
The idea is that asset classes come in and out of favor at different times. By rebalancing on a periodic basis, you shift money from classes just in favor to classes that were recently out of favor. In a sense, by doing this regularly, you are buying low and selling high. All the while you are minimizing your risk.
