ABSTRACT
People appear to organize, evaluate, and keep track of their financial activities according to a set of cognitive operations that treat money differently in different contexts. These decision processes are collectively known as mental accounting. When individuals are motivated to act according to mental accounting principles, they do not necessarily choose the most preferred available option, as assumed in the standard economic model of decision making. The primary focus of this chapter is understanding how the assignment of activities to different mental accounts can make sense of otherwise puzzling behaviors. The chapter begins with sunk cost effects and payment depreciation, before turning to consumption and savings decisions over the life cycle. Mental accounting of income and wealth can explain responses to bonuses, windfalls, government transfers, pensions, and home equity. The chapter concludes with a discussion of the tendency for people to diversify excessively when offered multiple options, each of which can be chosen. An extreme form of such diversification is the 1/n heuristic for financial investments.
