Mental Accounting

Mental accounting is a term that refers to a behavioral bias that can lead to less than optimal financial decisions. Mental accounting involves the separation of potential economic outcomes into separate and often arbitrary mental accounts. For example, a person may take their overall portfolio of assets and, in their own mind, separate those funds into accounts for education, retirement, a home purchase, etc. This separation of funds into various compartments can lead to financial outcomes that are inferior compared to what might occur if decisions are made in the context of the overall portfolio. When it comes to annuities, mental accounting is involved when people frame the annuity purchase decision in terms of gains and losses rather than their overall income and consumption profile.