Bull markets are extraordinarily effective at convincing their participants that they are permanent. This is not a coincidence. The psychological conditions that bull markets create—rising wealth, confirmed beliefs, social validation—are precisely the conditions that make scepticism most difficult to maintain. The investor who has watched her portfolio appreciate steadily for several years has accumulated a body of experience that feels like evidence: evidence that her strategy is correct, that the asset classes she owns are sound, that the economic environment is benign. Each passing month of positive returns reinforces this evidence base. By the time the bull market reaches its late stages, the accumulated weight of confirming experience makes the possibility of reversal feel remote and, to many investors, almost inconceivable.
The mechanism is a combination of recency bias and confirmation bias operating in mutually reinforcing fashion. Recency bias causes recent returns to feel representative of what the future holds. Confirmation bias causes the investor to interpret new information selectively, accepting evidence that the bull market will continue and discounting evidence that it might not. The longer the bull market runs, the more evidence has accumulated on the confirming side, and the more entrenched the belief in its continuation becomes. Paradoxically, the conviction that the trend is permanent tends to peak at the moment when the trend is closest to ending—because it is at that moment that the accumulation of confirming evidence is greatest.
The historical record on bull market duration and the relationship between valuation and subsequent returns is unambiguous, though not widely internalised. Long periods of above-average returns systematically produce above-average valuations, and above-average valuations systematically predict below-average forward returns. This relationship does not operate with the precision of a mechanism—markets can remain expensive for years before reverting—but over the periods relevant to long-term investors, it is among the most robust empirical regularities in finance. The investor who extrapolates a bull market's recent returns into the indefinite future is making a prediction that is inconsistent with virtually all historical precedent.
The specific error that bull market extrapolation produces is one of asset allocation. As returns have been strong and are expected to continue being strong, the investor increases her equity allocation—either actively, by buying more, or passively, by failing to rebalance as equities grow as a fraction of her portfolio. This concentration increases precisely as valuations rise and prospective returns diminish. The portfolio that felt appropriately risky at the beginning of the bull market has become, through a combination of appreciation and psychological recalibration, far more concentrated in expensive assets than the investor's actual risk tolerance would endorse if she were assessing the position fresh.
The corrective is a rebalancing discipline that operates mechanically rather than judgmentally. The investor who rebalances to target allocations at predetermined intervals—regardless of recent returns, regardless of current sentiment, regardless of what the financial media is saying about the outlook—is automatically selling what has appreciated and buying what has lagged. This is uncomfortable precisely because it requires selling the assets that feel like winners and buying the ones that feel like losers. It is also, historically, one of the simplest and most effective mechanisms for avoiding the worst consequences of bull market extrapolation.