Damage Reduction tends to be poorly understood, largely because there are so many forms of it. There's Armor, Magic Resistance, a plethora of champion abilities, and a handful of masteries that all purport to reduce the damage you will take. How all of these disparate factors combine to ensure one's survivability seems incalculable, but it's actually fairly straightforward.
Damage Reduction, as with many other mechanics, can be found in both percentage and flat forms. The former greatly outnumbers the latter for reasons we'll get to later. For now, here's the equation:
Damage Taken = Raw Damage * (Product of all % Damage Reduction Factors) - (Sum of all Flat Damage Reduction Factors)
Armor, Magic Resistance, and effects such as Alistar's ultimate are % Damage Reduction factors. When they are applicable they are multiplied together before reducing damage. This prevents abuse, as adding them together would potentially allow champions to reach 100% Damage Reduction. The Indomitable mastery and Amumu's Tantrum are Flat Damage Reduction factors, and they are subtracted from the damage at the end.
Which brings us to why Flat Damage Reduction is rare and comes in very limited forms. Damage reduction is calculated separately for every instance of damage, meaning that damage over time effects are calculated on a per tick basis. As a result, sufficient combinations of % Damage Reduction and Flat Damage Reduction can lead to invulnerability against damage over time abilities.
For example, Olaf's ultimate used to provide 40 Flat Damage Reduction. Many damage over time abilities tick twice a second, such as Malzahar's Malefic Visions. Because the Flat Damage Reduction applies to each tick, Malzahar would lose 320 damage trying to kill Olaf. Not only that, but if Olaf has 60% Damage Reduction from Magic Resistance, Malzahar would need a raw damage of 800 in order to even scratch Olaf. Flat Damage Reduction was simply too strong against damage over time abilities to remain a significant part of the game.
While % Damage Reduction can't be abused in the same way it is still strong. Because Armor and Magic Resistance have diminishing returns, other sources of % Damage Reduction increase in value. At high levels of Armor or Magic Resistance the mere 20% Damage Reduction from Maokai's ultimate can easily be worth 75 of either stat.
Ultimately this mechanic has a limited effect on item choice. The only item in the game which provides any form of damage reduction is Leviathan, the oft-forgotten snowball item for Health, but only if you reach 20 stacks. The vast majority of Damage Reduction comes from champion abilities, and much of it for very limited time frames. As with any other defensive steroid, you need defenses to fill in the gaps or else your enemies will simply destroy you during the downtime.
Hopefully that clears up the nagging questions about Damage Reduction which were obviously keeping you up at night.
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