With AI stocks skyrocketing to dizzying heights, caution bells are ringing across Threadneedle Street and beyond. The Bank of England has already flagged an AI “bubble” that could burst like the dotcom crash, sending shockwaves through the British economy. Microsoft founder Bill Gates has issued the same warning for global markets. “There are a ton of these investments that will be dead ends,” he told US broadcaster CNBC this week.

The so-called bubble refers to surging and unrealistic valuations of artificial intelligence (AI) companies, inflated by investor hype and speculation rather than sustainable profits. When a bubble occurs, it can set the stage for a sharp market correction, policymakers warn. Companies like OpenAI are currently valued at around $500 billion (£372 billion), up from $157 billion a year ago. One firm, Anthropic, has nearly tripled to $170 billion since March.

The Bank of England’s financial policy committee says AI-driven tech valuations look “stretched,” leaving markets vulnerable if optimism fades. It cautions that a “sudden correction” could “adversely affect the cost and availability of finance” for households and businesses.

Doubts are growing further after research from the Massachusetts Institute of Technology found that 95% of firms have seen no return from generative AI, raising fears that disappointing progress could trigger a sharp sell-off in AI-related stocks.

Historically, market bubbles have shared similar patterns. A transformative new technology sparks excitement, drawing heavy investment as investors bet on future winners. Optimism fuels rising valuations until reality sets in.

As Richard Flax, chief investment officer for digital wealth manager Moneyfarm, explains, “too much money chases too few opportunities, expectations deflate and asset prices fall.” Other examples include the 1990s telecom boom and the dotcom bubble, which involved investment in internet-based start-ups.

The bubble ballooned during the late part of the decade and then imploded in March 2000, causing a stock-market crash. However, Flax adds, “Bubbles don’t mean the technology has failed. It’s more that expectations about the scale and, importantly, the timing of adoption proved too optimistic.”

While there are clear warning signs, analysts say we’re not yet at the stage to start panicking. Underlying demand looks robust, profitability remains high, and most listed businesses investing in AI are highly cash generative.

Victoria Scholar, head of investment at Interactive Investor, points out that a recent Bank of America fund manager survey suggested that more than half of investors (54%) believed AI was in a bubble. However, they don’t seem to translate this view into more conservative market positioning.

“Investors continue to pile into equities, chasing riskier returns,” she adds. “Even though many believe that tech stocks are overvalued, there’s a simultaneous belief that there could be more room to run.”

Ben Barringer, global head of technology research at Quilter Cheviot, agrees that valuations in the sector have risen sharply but remain well below the extremes seen during the dotcom era, when some companies traded at more than 60 times their earnings.

“Today’s multiples are closer to half that level,” he says. “That still makes for an expensive market, but it is not necessarily a screaming bubble.” However, Barringer warns that investor behaviour is beginning to show familiar signs of exuberance.

“There has been a flurry of deals in the tech space as firms compete to become the ultimate AI winner, and retail investors have poured money into anything with an AI label attached. Momentum of this kind can be hard to sustain, and not every company in this ecosystem will thrive,” he says.

If the AI bubble were to burst, the impact would likely be most acutely felt in the US technology sector and among companies directly exposed to the AI supply chain, including chipmakers and cloud-computing providers.

“The US stock market would probably be hit hardest due to its heavy concentration in technology names,” says Barringer. A sharp correction in tech could still have ripple effects across broader markets, given the sector’s dominant weight in global indices.

“Many of these businesses have diverse income streams and strong balance sheets, which should help cushion the blow compared to earlier bubbles,” he adds. “Other regions and asset classes, such as bonds and commodities, would be less directly affected and could provide important balance during a downturn.”

Investments

While market volatility can be unnerving, Dan Coatsworth, head of markets at AJ Bell, advises investors to stay calm and avoid knee-jerk reactions.

“It’s important not to panic – markets go down as well as up, and we regularly see corrections. Staying invested has proved to be a wise decision, as the bounce-back can come hard and fast,” he says. He notes that it took just 190 days for the global stock market to fully recover from the 2020 Covid crash.

Coatsworth suggests reviewing portfolios to ensure proper diversification. “This means holding shares, bonds, commodities like gold, property, and exposure to different sectors and geographies,” he says.

Long-term investors should stay the course. “Someone with a long horizon should consider a regular investing plan, deploying a set amount each month regardless of what’s happening in the world. If markets fall, they’ll be able to get more for their money.” For cautious investors, he recommends money market funds, which have surged in popularity this year as investors look for lower-risk options in ISAs or pensions.

Ben Barringer also stresses the importance of spreading risk. “Diversification remains the single most important safeguard,” he says. “Spreading investments across geographies and industries reduces risk and helps smooth returns over the long term.”

Pensions

It’s normal for pension savers to feel uneasy during market swings, but Craig Rickman from Interactive Investor urges people to keep perspective.

“Stock market ups and downs are par for the course when investing for your long-term future,” he says. “The key is to manage volatility around your specific circumstances.”

Before making any rash decisions, he advises taking a step back and considering how a market slump would impact you. It won’t affect everyone’s retirement plans in the same way – it depends on factors like age, whether you’re drawing from your pension, and the type of pension you hold.

Rickman explains that Defined Benefit (DB) pensions, almost exclusively found in the public sector, won’t be affected by market falls because future income isn’t linked to investment performance. By contrast, with Defined Contribution (DC) schemes, if markets fall and you’re heavily invested in stocks and shares, your savings will fall too. For those with time on their side, there’s little reason to panic.

“Anyone who’s 10 years or more from retirement should have little need to hit the panic button,” says Rickman. “You still have plenty of time for things to recover, and history tells us they do.” He adds that falling stock markets can even work in your favour through pound-cost averaging, which can boost savings when things recover. However, those nearing retirement are more exposed.

“Significant market falls just before retirement can wipe thousands off your portfolio – and your pot might not have enough time to bounce back,” he warns. “Keeping two to three years of living expenses in cash or low-risk assets can provide breathing space for your portfolio to rebound.”

Savings

Rickman also emphasises preparation when it comes to savings. “While we don’t know whether the AI boom will trigger an economic crash, simple steps can help shield your investments from any storms,” he says. Good financial habits matter more than trying to second-guess markets. “

Keep an emergency fund equal to three to six months’ expenditure in an easy-access savings account. This acts as a safety net should you lose your job or face unexpected costs.”