Cracks tend to appear in the dike before the dike breaks. The first cracks that led to the 2007-2009 bear market formed in mid-2005 as the housing market began to cool off and defaults among subprime mortgages began to rise, according to The Federal Reserve and Vanguard. However, early on, the cracks were largely dismissed as Fed Chairman Ben Bernanke told Congress on March 28, 2007 that subprime defaults were "likely to be contained,'' and former Treasury Secretary Hank Paulson said on August 1, 2007, "I see the underlying economy as being very healthy," according to Reuters. Reassured, the stock market continued rising until early October 2007. 

Not all cracks in the dike lead to a major break. This is a really tricky part about investing--how to discern the difference between a cyclical issue and a secular issue. Cyclical issues are short-term blips that don't cause major long-term damage. Secular issues are multi-year problems that left untreated may cause real trouble. Overcompen-sating for the former and under-compensating for the latter is a bad combination. 

When a major break does occur, it can lead to massive flooding. Almost all traditional asset classes declined during the 2007-2009 bear market, so it was hard to find shelter from the storm. Even many of the so called "smart investors," such as hedge funds, discovered that they too were vulnerable to the market's vicissitudes, according to Bloomberg.

Hundred-year floods seem to happen much more frequently than theory suggests. Just since 1950, the U.S. has experienced 10 bear markets, defined as a drop of 20% or more from the market's previous high, according to Standard & Poor's. Excluding the most recent bear market, the average decline during these bear markets was 31.7%. And, don't forget, on October 19, 1987 the market dropped more than 20%--effectively a bear market in a day! This frequency of large declines makes it difficult to rely on modern portfolio theory as a panacea.

Dikes can be repaired and the flooding cleaned up. After each of the first nine bear markets since 1950, the stock market went on to reach a new all-time high. We are currently in the 10th bear market so the jury is still out on whether we'll hit a new one again. However, unless you think the world is coming to an end soon, chances are the stock market will regain its previous high. When that new high will happen is subject to fierce debate.

Bad floods may leave lasting damage--both physical and psychological. After particularly bad investment experiences, some investors yank their money from the market and seek safer pastures. It's akin to people who grew up during the depression and developed a lifelong habit of frugality; they were never quite able to shake the trauma of their early lean years. Financial wounds may heal, but scars persist.

People continue to build homes in flood-prone areas. The reverse from above is also true. Some people have short investment memories and quickly bounce back into their aggressive investment ways. Rather than learn from the past, they continue to repeat it and hope that they will somehow manage to dodge the next bullet.