INSPIRATION THROUGH OBSERVATION
Through observing and experiencing combat at some level, you internalize the dynamics of a fight. In doing so, you gain the ability to separate useful from useless techniques. When this is accomplished, the world of martial arts knowledge becomes an open library for reference and inspiration.
A formal school is a valuable resource. For many, it is the only way to effectively study martial arts. This is especially true for the novice. Even so, you should not rely on merely being taught. When skills reach the point of actual application, you must think for yourself. It is your responsibility to actively learn, rather than passively following instruction.
SEEKING QUALITY INSTRUCTION
It is no secret that there are many substandard dojos. I do not think that this is an affliction of modern times. Things change very little in the long run. Whether or not weak schools were so prevalent, there have always been good and bad instructors, strong and weak styles. The devastating skills of the martial arts still exist today, as all things of quality do, amidst the sea of lesser imitations. It is up to you to recognize the real thing when you encounter it.
An instructor does not have to be perfect at every skill, but his overall ability must be honestly assessed. If he is proficient at forms, but obviously misunderstands fighting application, then he has missed the purpose of true combative arts. Conversely, a naturally huge, strong, or fast individual can be a formidable fighter, but without knowledge of certain skills, he is not qualified to represent a system. He cannot teach students how to be naturally big, strong, or fast.
It is fortunate if you manage to find an instructor who is skilled in fighting, but this is not always the case. Many instructors can teach the methodology of an art without possessing the ability to actually apply it. This does not necessarily mean the instruction is not valid.
A good instructor does not necessarily need to be able to apply combat skills effectively. For instance, he may be too small, too old, or both. What he must absolutely be able to do is guide you to effectively apply the skills. Seeing what a prospective instructor can personally do is fine, but seeing what his students can do is the most relevant concern. It is common for an excellent coach to be physically outmatched by his top students. This is a good sign.