# Asset Allocation

Source: https://www.yieldcurve.pro/learn/asset-allocation

**Asset allocation** is the process of dividing a portfolio among different asset classes — most fundamentally, equities and bonds — to achieve a desired balance of return and risk. Research consistently shows that asset allocation explains the majority of portfolio return variation over time, far more than individual security selection.

The key inputs to any allocation decision are:

- **Expected returns**: the [equity premium](https://www.yieldcurve.pro/learn/equity-premium) over the risk-free rate, and the expected return on bonds (driven by yield levels and the [term premium](https://www.yieldcurve.pro/learn/term-premium))
- **Volatilities**: the standard deviation of returns for each asset class
- **Correlations**: the [stock-bond correlation](https://www.yieldcurve.pro/learn/stock-bond-correlation) determines how much diversification benefit bonds provide
- **[Risk aversion](https://www.yieldcurve.pro/learn/risk-aversion)**: the investor's tolerance for drawdowns and volatility

The classic starting point is the [60/40 portfolio](https://www.yieldcurve.pro/learn/60-40-portfolio), which allocates 60% to equities and 40% to bonds. However, the optimal allocation varies substantially based on the investor's age, income stability, and the prevailing market environment.

[Lifecycle investing](https://www.yieldcurve.pro/learn/lifecycle-investing) extends static allocation by adjusting the stock-bond mix over time as [human capital](https://www.yieldcurve.pro/learn/human-capital) declines with age. Young investors with decades of future income can afford to hold more equities; retirees drawing down savings need more bonds.

The yield curve environment directly affects allocation decisions. When yields are high, bonds offer competitive returns and stronger diversification (assuming negative stock-bond correlation). When yields are near zero, the opportunity cost of holding bonds is low but so is their expected return, pushing allocations toward equities or alternative assets.