What are NFTs? An Investor’s Guide to Investing in Non-Fungible Tokens

You’ve heard about them by now: non-fungible tokens, or NFT’s for short. These new investments have taken the world by storm, turning digital works of art and collectibles into easily tradable items on the blockchain.

A close-up of a web browser showing the CryptoKitties NFT platform.
Source: Ricky Of The World / Shutterstock.com

But what exactly are NFTs? How have artists and organizations, from Grimes to the NBA, created millions of dollars in sales? And most importantly, how can regular investors get in early enough to make big profits?

The answers are more straightforward than you think. Though the whole NFT system relies on novel blockchain technologies, the concept of titling and deeding properties has existed since ancient times. And the faster you realize that, the sooner you can concentrate on finding the best investments that will go up in value.

The $1 Trillion Opportunity

Today, the global collectibles market alone is worth almost $400 billion. Classic cars, comics books, fine wines and even film props have earned places in collector homes and museums.

Once you add in the total value of all artwork ever produced, the figure likely tops $1 trillion. Rembrandt, a 17th-century artist, created more than 600 paintings in his lifetime, with each typically fetching eight-figure sums.

Today, we stand at the precipice of change. The NFT market means that you could start making money from things that were once untradable – digital art, music, and even your tweets on Twitter could get sold to a willing audience. And even the traditional world of physical art and collectibles may join the NFT revolution.

This is a market you need to know.

What Does NFT Mean?

NFT stands for non-fungible tokens, an electronic token representing something unique, say a digital piece of artwork or a website domain name. These tokens, in turn, use cryptocurrencies like Ethereum or Cardano to run and validate.

Keep in mind: the NFT isn’t the item itself. Just like a house deed or car title, the NFT represents ownership in the thing. It tells everyone else in the world that you own something, and no one else can lay claim to it. Internet domain names, for example, can get backed by NFTs.

And it gets even better. Because unlike deeds and titles, NFTs can represent virtually anything – a car, an NBA highlight reel, or even a GIF image of a pop-tart cat flying through space. If it’s a unique item that you can lay a legitimate claim to, you can create an NFT for it and make money trading it.

There are some limits. Easily substituted items like dollars or Bitcoin, for instance, can’t become NFTs. There must be some differentiating factor to stake a particular claim on. Non-ownable things also can never become NFTs. A seller might try creating an NFT representing the planet Mars, but no sane investor would buy it. After all, no individual can legitimately lay claim.

Still, there are some crossovers. A 1794 Flowing Hair Silver Dollar (a rare coin that sold for $10 million in 2013) is technically a minted dollar. But it’s rareness and historical significance means it holds a value far beyond its original amount. An NFT representing a similar asset will act the same way.

Are NFTs Good Investments?

We’re admittedly a strange species. Over centuries, we’ve made multiple billion-dollar industries around collectibles and artwork. Not only are millions of people employed in creating these items. Today, mega-cap companies from high-end auction houses Sotheby’s and Christie’s to online firms like eBay and Etsy help us transact and earn a living from our collections. People spend small fortunes on insurance against fraud and damage. And people in the know can get quite wealthy.

NFTs are an extension of the same principle. Though digital artwork is faster to copy and distribute, many people still have a fundamental desire to own the original piece. A combination of love and pride drives many; Brunei’s Sultan reportedly owns 7,000 cars in his collection.

But others want to reward the original artist for creating something they enjoy. You’ll find thousands of small digital artists selling works for less than $100. And if you like a particular artist, I’d strongly recommend you buy an affordable piece or two, even if to give the creators some financial support to keep doing their work.

But if you’re in it for the profits, you’re probably asking one thing. Are NFTs winning investments?

Here’s the secret: NFTs are only as good as their underlying asset.

The famous Nyan Cat Gif sale of $590,000, for instance, could have only reached that value because of the meme’s incredible popularity through the years. Similarly, the NBA’s highest-selling NFT was of a LeBron James highlight reel, which sold for $200,000. Less famous players, meanwhile, had reels that sold for as low as $9.

In other words, to make money from NFTs, investors need some unique insight into the assets they represent. Keen NBA watchers who can correctly identify future NBA superstars could buy cheap highlight reels today and earn millions when the stars break out several years from now. Steve Nash and Kobe Bryant both had awful rookie seasons (the 18-year-old Kobe scored just 7.6 points per game!) But both would become superstars in their later years. And any team who bet early on them would have won handsomely. Meanwhile, those buying NFTs of NBA one-hit-wonders during their 15 minutes of fame won’t do nearly as well.

Similarly, the art world has always seen its shares of stars and duds. Many of Banksy’s first pieces, a well-known street artist, were painted over by authorities who mistook them for graffiti. Meanwhile, his later pieces would go to sell for as much as Rembrandt at auction. It’s often problematic for regular people to tell the difference between masterpieces and standard works of art. In other words, if you want to make a lot of money in NFTs, make sure you’re focusing on your area of expertise. If you’re a video game player, look into Decentraland, a digital world backed by Ethereum (CCC:ETH-USD). If you’re a sports fan with an eye for talent, then the NBA’s NFTs could be for you. And if you know art or music, then focus on that as your area of expertise.

It’s the same principle that’s held with stocks for decades.

How to Invest in NFTs?

Investing in NFTs involves two leaps of faith. The first is obvious: the underlying asset must have significant and growing value. It’s pointless to buy a piece of digital art if you believe the artist will churn out infinite copies of the same thing.

The second leap of faith is a little more complicated: NFT buyers need to trust the cryptocurrency system itself. When you invest in an NFT, you’re assigned a token that tells the world you own a specific asset. That’s often done on the Ethereum network, a system that runs the Ether currency. But new coins, like Cardano (CCC:ADA-USD) and Polkadot (CCC:DOT1-USD), are starting to also get in on the game.

So how do you reduce your risk? When you buy an NFT, you need to be sure no one else owns that property off-chain already. In the real world, an entire industry of title insurance makes sure you’re not buying a property where the seller has faked his or her ownership. But in the world of NFTs, you need to do your homework to ensure you’re not getting an altered or copyrighted item.

That means investors should also limit their exposure to any single NFT. Even if you believe an asset could double or quadruple in value, it’s usually wise to limit yourself to 5% to 10% of your total investible portfolio in case something goes wrong. Even the best investments can go to zero under the worst circumstances.

At the same time, don’t spread your bets too thin. Buying a thousand pieces of low-quality digital art might come cheap, but even a 10x winner won’t move the needle.

Where to Buy NFTs?

Today, many reputable trading sites have popped up to serve the NFT community.

Rarible. The world’s largest NFT marketplace has hosted more than 30,000 users in the past month. Most of these sales are small pieces of digital art worth in the tens or hundreds of dollars.

OpenSea. The second-largest NFT market hosts fewer users but has more volume because of its higher-ticket items. Users can buy domain names, digital art and trading cards on this site.

SuperRare.co. The average sale on the site goes for over $10,000, according to Dappradar, an NFT tracking site. The site specializes in higher-end digital artworks and has professional curators suggest artworks.

Direct. The NBA, for instance, hosts a site to sell highlight reels. Other sites like Decentraland operate independent marketplaces for users to trade digital goods.

Regardless of where you choose to buy, know this: make sure you’re buying something that’s 1) limited in quantity and 2) high in quality.

What’s Next for NFTs?

NFTs represent one of my favorite areas for investment in 2021. Digital art is valuable in the eye of the beholder, and NFTs make it possible to own a piece of this world.

There’s also an entire, undiscovered world of new NFTs. Jack Dorsey’s original tweet sold for $2.5 million in March, opening the door for other similar transactions. And entire digital worlds are finally getting the monetization that users have long dreamed. Auction sites like eBay have long banned sale of in-game items, so the introduction of NFTs can mean safer ways for gamers to sell their efforts to others.

Even physical artworks may one day get traded via NFTs. Today, hundreds of sites claim to produce certificates of authenticity for everything from paintings to autographs. Securing all that on a single blockchain could make authenticating and trading these collectibles easier than ever before.

So, what does that mean for regular investors? Firstly, investors should expect prices of digital art masterpieces to rise. NFTs help collectors validate ownership, which lowers the risk of fraud and piracy. Secondly, don’t be surprised if the price of real-world collectibles also rise. Trading cards have seen their values skyrocket from renewed interest in trading, and NFTs can make transactions easier to handle. Finally, beware of unexpected risks. Jack Dorsey’s iconic original tweet might go up in value, but many NFTs will also fizzle out before people understand what things are worth.

As always, be careful of how you invest. It’s a great time to be in NFTs, but don’t put more money in than you can lose.

On the date of publication, Tom Yeung did not have (either directly or indirectly) any positions in the securities mentioned in this article.

Tom Yeung, CFA, is a registered investment advisor on a mission to bring simplicity to the world of investing.

Article printed from InvestorPlace Media, https://investorplace.com/what-are-nfts-an-investors-guide/.

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