What is a bubble? Understanding the financial term.

Illustration of a hand holding a pin about to poke and deflate a balloon in the shape of the letters "ai"

Wall Street is ‘growing louder with warnings that the artificial intelligence trade may be overheating’

(Image credit: Devrimb / Getty Images)

We have endured the dot-com bubble and the housing bubble. And now, according to some experts, we may be in an AI bubble.

As of mid-October, Wall Street is “growing louder with warnings that the artificial intelligence trade may be overheating” following “months of record gains in AI-linked stocks and corporate spending,” said Yahoo Finance. Still, “some analysts argue the market’s strength reflects conviction, not complacency, and that the AI trade, while stretched, still has fundamental backing.”

Only time will tell which side is right when it comes to the potential AI bubble. But in the meantime, you can brush up on what exactly a bubble is — and what the consequences of one popping may be.

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What is a stock market bubble?

A stock market bubble is a “significant run-up in stock prices without a corresponding increase in the value of the businesses they represent,” said The Motley Fool. Usually, this is driven by “highly optimistic market behavior,” said Investopedia. Then, when investors’ sky-high levels of optimism start to wane as they realize their hopes are not panning out, they all begin to sell off, sending stock prices tumbling and causing an abrupt contraction in the market.

Take, for example, the dot-com bubble of the late 1990s: In the lead-up to this bubble bursting, “investors piled into any stock of just about any company with a website, regardless of its share price, revenue or profit outlook,” said U.S. News & World Report. Later, “when the dot-com bubble burst in 2000, the Nasdaq Composite Index dropped nearly 80% over the next two years.”

What are the signs of a bubble?

Surging stock prices do not necessarily indicate a bubble — assuming they are bolstered by a company’s strong performance. If, however, there is a mismatch between the information and the valuation, that could suggest a bubble. “During the height of market bubbles, prices often continue to rise even following bad news, such as earnings misses or analyst downgrades,” said U.S. News & World Report.

Bubbles frequently emerge from stocks that carry a “compelling story” with a “promise to transform the world,” such as the advent of the internet, said Bankrate. This usually leads to widespread enthusiasm, with bubbles “marked by large groups of novice or amateur investors who believe experienced investors are behind the curve or simply just don’t ‘get’ the new market paradigm,” said U.S. News & World Report.

How can a bubble affect investors?

While bubbles can benefit investors who get in early, “many investors end up losing a lot of money during market bubbles because they don’t start buying until asset prices are already significantly overvalued,” said U.S. News & World Report.

The effects of a bubble are not necessarily isolated to those who chose to invest, either. When a bubble bursts, it tends to precede a “downturn in the economy, creating a recession,” said Bankrate, which can lead to declining portfolio values and even layoffs.

Becca Stanek has worked as an editor and writer in the personal finance space since 2017. She previously served as a deputy editor and later a managing editor overseeing investing and savings content at LendingTree and as an editor at the financial startup SmartAsset, where she focused on retirement- and financial-adviser-related content. Before that, Becca was a staff writer at The Week, primarily contributing to Speed Reads.