Amid growing concerns over the excessive frenzy surrounding artificial intelligence (AI), valuation expert Aswath Damodaran said in a recent podcast that the AI bubble is coming and there is no way to avoid it completely.

To explain how we got into this mess, Damodaran says we have to go back to November 30, 2022, when OpenAI unveiled ChatGPT, what was then a revolutionary AI chatbot. He noted that ChatGPT was then a low-tech AI chatbot, but in many ways, it brought nascent artificial intelligence into public consciousness.

"You bring the two together, powerful computing and this immense amount of data, you have AI," the Dean of Valuation quipped. He explained that artificial intelligence had been around for a long time, but what ChatGPT's public debut in November 2022 did was bring the technology into the spotlight.

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Why Damodaran is worried about his grandkids

Today, AI is everywhere. It is in classrooms, businesses and even entertainment. “No matter what age you are, it is not just that you worry about your portfolio, which might be doing very well at the moment if you have got an index fund. You worry about the world around you changing in a way that you don't recognise anymore. That's what is scaring people,” he said on the ‘Disruptor Confessions’ podcast.

Speaking about the potential disruption that the AI bubble could bring, Damodaran noted that people in their 20s and 30s are in the target zone. “I look at my grandkids who are eight, six, and turning – and just turned one, and I wonder what kind of world they are going to go into. Because if they ask me for advice, I would not be able to give them advice because the world has shifted from the world that I knew.”

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Damodaran on AI bubble worries and impact on stock market

The valuation expert noted that stock markets have always been top-heavy, with the Magnificent Seven (Mag 7) accounting for a significant share of the US market's total value. "You are getting more winner-take-all businesses, and the winners, of course, walk off with trillions of dollars of market cap. So technology has changed businesses. They are becoming more momentum-driven," he said.

Damodaran said index funds have partly contributed to this concentration in the stock market. He explained that an S&P 500 index fund allocates investors' money to constituent companies in proportion to their market capitalisation, meaning larger companies receive a greater share of the investment.

This trend continues until a major surprise disrupts the market, the analyst noted. For instance, the housing sector attracted the bulk of investment ahead of the 2008 global financial crisis. Similar surprises and their subsequent market impact were seen during the dotcom crash.

Damodaran said investors often ignore market risks, believing that stocks will eventually recover. However, those who experience a massive market crash feel its impact firsthand as their portfolios collapse and savings disappear. The analyst believes such crashes serve as the market's way of teaching investors a lesson in risk management.

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Damodaran explains why holding cash may not be fruitful

Should you sell all your stocks and sit on cash? Damodaran noted that many investors panic and sell everything to simply hold cash amid market uncertainty. However, this often fails to beat inflation and turns out to be counterproductive. These investors try to time the market but end up spending too much time out of it, trying to catch the bottom.

“At least with equities in the US, staying out of the market more than offsets whatever you gain by staying through a catastrophe. If you really need the cash in the near term, of course you should cash out. Put your money in T-bills because you need the cash. If you don't need the cash, you're probably better off letting it ride, knowing there's gonna be a correction, knowing you'll feel pain the day after the correction, but knowing that you have time to make it up as the money back,” he said.

Damodaran says bubbles are market features, not bugs

Damodaran dislikes the word 'bubble', but believes bubbles are features, not bugs, of the market. In the current AI bubble, he feels it is tougher to stay away from AI because everybody seems to want to “put their finger in the pie”. However, if an investor is not invested in Anthropic, OpenAI, SpaceX or the Mag 7, they can avoid the worst of the AI-related pain, according to the analyst.

When the AI correction comes, data centres funded with debt will run into problems as they may not be able to generate sufficient revenue, leading to defaults on their debt, the Dean of Valuation said, adding that debt defaults would become everybody's pain.

Damodaran worries about the broader consequences of an AI correction, given the scale of the investment bet and the potential magnitude of the downturn. He said the economic, political, social and cultural consequences could make the 2009 blowback look like small fry.

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What to do before the bubble bursts? Damodaran explains

Damodaran believes investors should stay calm and avoid expert advice amid the chaos, as it is likely to be mostly short-term oriented. His advice to investors is to have a plan in place before the correction begins, including setting limit-sell orders on their investments.

“If this happens and this happens, I am gonna limit sell and convert to cash. Because in the face of maximum uncertainty, human beings stop acting, and we all have to be aware of that. It is built into our genes to panic because everybody else is panicking, and you want to try to kind of create processes that'll act for you when you're unable to act,” he concluded.

Disclaimer: This article has been written by Debaroti Adhikary, who is not a SEBI-registered Research Analyst or an Investment Adviser. Debaroti Adhikary and his/her ‘relative(s)’ (as defined under Section 2(77) of the Companies Act, 2013) do not hold any financial interest in the companies mentioned in this article as of the date of publication. The views/recommendations mentioned in this article, wherever applicable, are those of the respective SEBI-registered Research Analyst/brokerage and have been reproduced/reported with due attribution. They should not be construed as the views or recommendations of The Economic Times Digital or the journalist. Readers are advised to consider the original research report and make their investment decisions based on their own assessment. Brokerage disclaimershere.