Asset allocation refers to the selection of securities and asset classes in which one can invest. It's the same idea that you might hear referred to as "portfolio composition" or, more simply, "investing mix."
The most common types of securities for investors are stocks of publicly traded companies (shares of Apple and General Electric, for example) and bonds (such as a 10-year U.S. Treasury bill issued by the government). Stocks and bonds are themselves divided into asset classes, like large-cap, mid-cap and small-cap stocks, which are references to the size of the company; U.S. stocks vs. international developed world stocks; developed world stocks vs. emerging markets stocks; government bonds vs. corporate bonds; and investment-grade corporate bonds vs. high-yield bonds.
Read MoreWhat is the yield curve?
And asset allocation is more than just stocks and bonds. Simply having cash under the mattress or something similar (e.g., money in a bank checking account or a money market fund) is an asset class by itself. And other possessions, like a house, a car or even an expensive piece of jewelery can be considered part of asset allocation, because they have value and in theory can be sold.
There are additional types of assets beyond stocks and bonds, making the choices even more difficult. For institutional investors, "hard assets," also referred to as "real assets," can include farmland, timber, other real estate holdings and commodities, like metals. Investment firms also sell retail investors on these means of diversifying their assets, such as buying gold- and silver-focused securities; and more complicated funds that put investor money in real estate projects (so-called REITs) or oil and gas pipelines (MLPs), for example.
Regardless of how someone allocates their assets, virtually everyone should practice some type of diversification to lower the risk of losing a lot of money at once—the less diversified a portfolio is, the greater the volatility, because the decline in one asset exerts too great a toll on the portfolio's performance.
Read MoreFederal funds rate: CNBC Explains
The Securities and Exchange Commission compares different asset allocations to a sidewalk vendor selling both umbrellas and sunglasses.
"Initially, that may seem odd. After all, when would a person buy both items at the same time? Probably never—and that's the point," the SEC explains on its investor-education website.
"Street vendors know that when it's raining, it's easier to sell umbrellas but harder to sell sunglasses. And when it's sunny, the reverse is true. By selling both items—in other words, by diversifying the product line—the vendor can reduce the risk of losing money on any given day."