A sustained bull market is one of the most effective generators of false investment confidence available. It provides years of confirming evidence for whatever strategy the investor happens to be employing, creates the impression of skill in an environment where almost any approach produces positive returns, and sets up the subsequent bear market as a devastating test of convictions that were built on inadequate foundations. The investor who developed his approach during a bull market and has never managed it through a significant sustained decline is not a tested investor; he is a lucky one who has not yet been tested.
The mechanism is straightforward. In a rising market, the relationship between the quality of an investment decision and its outcome is weak. A poorly reasoned decision to buy an overpriced stock in a sector that the market favours will produce gains if the market continues to rise; a well-reasoned decision to avoid that stock will produce the opportunity cost of missed gains. The outcome signal—the portfolio return—contains far more noise than signal about the quality of the underlying decisions, because the market's movement overwhelms the effect of individual stock selection in determining returns.
The investor who experiences several years of positive returns in this environment does not experience them as lucky; he experiences them as the product of his analysis and judgment. The positions he bought went up, which confirms his ability to identify good investments. The positions he avoided declined or underperformed, which confirms his ability to identify bad ones. The narrative of skill that emerges from this experience is entirely coherent—it is just wrong, because the confirming evidence is largely a product of the market environment rather than of the investment decision quality it appears to validate.
The specific danger is the position sizing and risk management decisions that result from bull-market-generated confidence. The investor who believes, on the basis of several years of positive returns, that he has genuine stock-picking ability will hold concentrated positions that are appropriate for someone with genuine edge but dangerous for someone whose returns have been driven primarily by market beta. He will use leverage that amplifies returns in a rising market and losses in a declining one. He will be underhedged because his experience of the market has been benign and hedging costs money that seems unnecessary when the portfolio is consistently generating positive returns.
When the bull market ends—as it always does—the investor who mistook market conditions for personal genius discovers the quality of his actual convictions. Positions that appreciated because the market rose, not because the underlying businesses outperformed, decline along with the market. The concentrated bets that expressed high conviction prove to be expressions of recency bias rather than genuine insight. The leverage that was comfortable in the bull market becomes destructive in the bear market. The genuine test of investment skill is not performance in a favourable environment; it is performance, and more importantly behaviour, in an unfavourable one. The investor who has not been tested by a sustained bear market should hold his self-assessment provisionally, regardless of how impressive his bull-market record appears.