You’ve heard about them by now: non-fungible tokens, or NFTs 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.

What does NFT Stand for?

NFT stands for non-fungible token, a piece of data on a blockchain (token) that represents some unique asset (i.e., a non-fungible asset).  These underlying “things” can range from digital artwork to website domain names. Even some physical goods and concert tickets have been bought and sold as NFTs.

What is an NFT?

An NFT is a long string of digits and letters representing ownership of something unique, say a piece of digital art or a website URL. Think of it as a receipt of purchase confirming that you are that object’s rightful owner. In practice, that means you’re buying and selling digital codes instead of the asset itself. 

Keep in mind that the NFT is only a representation of what you’re buying. House deeds and car titles work in a similar way — no one drives their car into the DMV lobby, since showing a vehicle title works just as well.

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But there’s one big difference with NFTs.

Unlike deeds and titles, NFTs can represent virtually anything – a music clip, an NBA highlight reel, or even a GIF image of a pop-tart cat flying through space. Even real world items are now tradeable via NFTs. As long as it’s a uniquely identifiable asset, you can turn it into an NFT.

Are NFTs Good Investments?

NFTs are only good investments if their underlying assets have promise. Turn a multi-million dollar piece of digital art into a limited-edition NFT and you can expect the token to have value. Do the same with one of my napkin doodles, and all you’ll get is a hint of what I had for lunch.

In other words, buying good NFTs is much like investing in any other collectible:

Quality and popularity matters.

That’s why famous pieces like Beeple’s “Everydays – The First 5000 Days” sold for millions while unknown ones go unsold. Similarly, the NBA’s highest-selling NFT was of a LeBron James highlight reel, valued at $200,000. Less famous players have reels that sell for as low as $9.

How to Invest in NFTs

Investing in NFTs involves five key steps.

1. Open a wallet. The more common choices include MetaMask, Coinbase, WalletConnect and Fortmatic. Make sure you choose a wallet with high security standards that best suits your needs.
2. Fund your wallet with cryptocurrency. Investors typically need to open an account on an exchange like Coinbase or Binance to convert real money into cryptocurrency. Once that happens, you can transfer money into your new crypto wallet in anticipation of a purchase.
3. Find an NFT to buy. I can’t emphasize this enough: make sure to do your research. NFT exchanges like OpenSea and Rarible offer hundreds of thousands of choices. But much like eBay or Craigslist listings, only a small fraction of these pieces will be worth pursuing.
4. Place a bid. Most NFT sites give owners several days to decide whether to accept offers. So stay patient and don’t jump the gun raising your bid just because there’s no movement.
5. Pay for the NFT and applicable fees. Once your bid is accepted, you’ll be charged for the NFT and any transfer fees (also known as “gas fees”). Then it’s time to enjoy your NFT.

Investing in NFTs also involves two leaps of faith. The first is obvious: you need to believe that the underlying asset has significant and growing value (though you can also buy NFTs purely to support the artist).

The second leap of faith is a little more complicated: NFT buyers need to trust the underlying blockchain 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 (ETH-USD) network, a system that runs the Ether currency. But new coins, like Cardano (ADA-USD) and Polkadot (DOT1-USD), are also starting to also get in on the NFT market.

What are the risks of investing in NFTs?

There are three key risks of investing in NFTs:

1. Prices can decrease. Fine wine… Gold… Beanie Babies… no collectible asset is safe from losing value.
2. Your account can get hacked. Today’s vault-breakers no longer need dynamite or drills. Accidentally downloading the wrong software is enough for hackers to acquire your wallet password and steal your NFTs.
3. You can (accidentally) buy fake NFTs. Despite some minor efforts by NFT exchanges, scammers still routinely sell other people’s work.

So how do you reduce your risk? When you buy an NFT, you need to use some common sense.

That’s surprisingly unnecessary in the world of traditional investing. When you’re buying a house, title insurers make sure you’re not getting scammed. And the SEC generally does a good job in banning outright frauds in stocks and bonds, at least on major companies.

But in the world of NFTs, no one’s warning you about stolen pieces of art or inflated prices.

That means you should limit your 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 investable 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 seem tempting, but transaction fees will quickly eat into any potential profits.

Are NFTs Scams?

NFTs are not scams. For the most part, anyway.

Instead, these non-fungible tokens are a new way to assign ownership to digital goods. If you want to claim the rights to a unique digital asset, NFTs provide a systematic way to track which pieces belong to who.

So why can’t someone simply copy-paste an NFT of a jpeg image and call it your own?

Well… you can. But attitudes are changing.

In the late 1990s, the music industry struggled with similar problems of piracy. Peer-to-peer sharing services like Napster would almost bankrupt record labels before alternatives like Apple (NASDAQ:AAPL) and Spotify (NYSE:SPOT) saved the day.

Today, NFTs are creating the same lightbulb moment in digital art. These tokens are increasingly seen as a way to compensate digital artists for their efforts.

What Are the Problems with NFTs?

Some of the problems associated with NFTs include:

• Lack of copyright protections. Owning an NFT of digital art doesn’t prevent users from copying your piece.
• Environmental costs. Ethereum and other Proof-of-Work (POW) protocols can consume up to 300 Kwh of power per transaction — enough to power an average house for a day.
• Security. NFT decentralization means that no central body can help you retrieve stolen passwords or assets. If hackers steal your password, no one can stop them from emptying your account.

Many of these problems are slowly but surely being addressed. Ethereum plans to launch an energy-efficient “Proof of Stake” (PoS) protocol that will reduce NFT energy consumption by 99% or more. And companies like Coinbase (NASDAQ:COIN) are creating centralized marketplaces where users will likely enjoy more protections.

But until these issues get resolved, problems with NFTs will continue to make them riskier-than-average investments for the ordinary investor.

Where to Buy NFTs?

You can buy NFTs on trading sites such as:

• Rarible. The world’s largest NFT marketplace hosted more than 30,000 users in the past month. Most of these sales were 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 trade 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.

Do you have to use crypto to buy an NFT?

Most sites currently require crypto to buy NFTs. For the most part, you’ll need to use Ethereum, Tezos (XTZ-USD) or Solana (SOL-USD) to get in on the game.

That could soon change. In January 2022, Coinbase announced a partnership with Mastercard (NYSE:MA) to offer cash-based NFT purchases. Bitcoin NFT purchases could soon follow thanks to the development of cross-chain bridges. Though buyers will still need a crypto wallet to store their NFT, advances in payments will make transactions smoother and lower-cost.

How do NFTs use blockchain?

NFTs use blockchain in two ways. 

• NFT Storage. Blockchains are essentially massive transaction ledgers that track which NFTs belong to which wallets. And because blockchains are public, anyone can verify ownership at any time.
• NFT Transactions. Blockchains are also useful in creating secure bidding contracts. If you want to sell an NFT to a buyer, the NFT exchange can quickly verify the funds and create a transaction that’s safe from chargebacks.

These properties make blockchains ideal for NFTs.

How does flipping NFTs work?

Flipping NFTs works by buying up NFTs for cheap and then selling them at a higher price.

Much of this relies on buying what you know (or having extremely good luck). Shrewd NBA watchers often buy cheap NFT highlight reels of future NBA superstars, then flip the tokens after the stars break out. And those with a keen sense of art or music can scoop up diamonds in the rough to resell at a later date.

Some investors also add value to their NFTs. Those owning parcels of land in Decentraland have earned hundreds of thousands of dollars by building digital houses, scenery and collectibles on their plots. All you need is some basic knowledge of Decentraland’s software development kit.

Put another way, flipping NFTs is much like flipping any other asset — the most successful flippers rely on their own plans rather than hoping the market intervenes.

How are NFTs taxed?

Though tax rules are still murky, most tax experts agree that NFTs are taxed as ordinary income, which subjects them to rates as high as 37%.

That could soon change. If the IRS recategorizes tokens as “collectibles,” that would lower the top long-term capital-gains rate to 28%. Taxing NFTs like cryptocurrencies and stocks would reduce the top rate even further to 20%.

Regardless of what rules get passed:

If you sell an NFT for a large profit, make sure you retain a portion of the proceeds until you pay off the tax bill.

How do I make an NFT?

You can make an NFT by digitizing virtually anything, whether it’s artwork, music or sounds of your dog barking.

Most digital artists start off small by creating single pieces of work. Any editing software will do, as long as it produces an image that’s sharable and viewable by others.

Meanwhile, those putting together 10,000 piece collections typically use a combination of programming and foundational artistic elements.

And if you don’t have art or programming skills, don’t worry. NFT artists have sold photographs, selfies and even Tweets. Today, a growing industry of freelancers has also surfaced to help would-be creators get their projects off the ground.

How do I sell an NFT?

To sell an NFT, creators need to follow a six-step process:

1. Create a crypto wallet. Wallets are essential for storing cryptocurrencies and the NFTs you produce. Popular choices include MetaMask and Coinbase Wallet.
2. Fund your crypto wallet. Selling NFTs also involves transaction and minting fees. These costs can range anywhere from $100 for single pieces to several thousand dollars for larger collections. Fortunately, some sites like OpenSea don’t charge upfront fees (i.e., gas costs) until your first sale. But to sell on sites like these, you still need to connect your wallet before you can list.
3. Choose a listing platform and connect your wallet. Most new NFT sellers tend to choose OpenSea or Rarible — the two largest NFT platforms. Both sites make it easy to sell NFTs. Simply visit their website, create a profile and follow their instructions on connecting wallets and minting NFTs.
4. Choose a selling price. Blockchains can charge high transaction fees, so sellers looking to make a profit typically need to start bidding prices at $200 or more. There’s little point in asking for $5 if you need $50 in gas fees.
5. List your NFT. Once you have your NFT created, it’s time to sell! On OpenSea, click the “Create” button to start a new item. You’ll have an option to create timed auctions or fixed-price listings. On Rarible, the process is similar. The site will ask whether you want to choose a single file or collection, and then give you the option for “fixed-price,” “open for bids” or “timed auction” sales.
6. Market your NFT. Most sales don’t happen by themselves. Once you have your artwork online, make sure you promote it on social media or through your personal network.

Are NFTs just for art?

NFTs are not just for art.

• Domain Names. Sites like “artdao.eth” and “wei.eth” have exchanged hands for six-digit figures.
• Music. Investors can now buy anything from short music clips to entire played-out symphonies.
• Sports. Trading cards, highlight reels and NFT games have all become highly traded assets.
• Virtual Worlds. Virtual real estate, collectibles and access passes are available to the avid collector

More bizarre NFTs have also surfaced, including a “cyber perfume” that sold for $18,000 and Jack Dorsey’s first tweet (going price: $2.9 million). Though the real value of these collectibles remain in question, that hasn’t stopped millions of people from investing anyway.

As the NFT market develops, don’t be surprised if entirely new categories surface.

What’s the size of the NFT market?

The NFT market is currently worth $41 billion, according to blockchain data company Chainalysis. 

That figure, however, is a moving target. Even established NFTs like the Bored Ape Yacht Club and Cryptopunks can see values swing wildly over the course of months, if not days.

The size of the NFT market is also affected by “wash trading,” the practice of selling NFTs to yourself to create the illusion of demand. In October 2021, a CryptoPunk “sold” for more than $500 million before making an immediate trip back to its original owner, showcasing the ease of creating illusory demand.

Nevertheless, we know that the NFT market is growing. Even if the $22 billion that people spent on NFTs in 2021 included some wash sales, it’s far higher than the $100 million spent the year before.

Are NFTs bad for the environment?

NFTs can be bad for the environment. Today, over three quarters of NFT trading happens on the Ethereum blockchain, a Proof of Work (PoW) protocol that consumes around 300Kwh of energy per transaction. That same amount could power the average American house for a full day. Critics of NFTs have complained that the system is both unnecessary and entirely wasteful.

There are some changes around the corner. Energy-efficient blockchains like Tezos and Solana are gaining market share thanks to their lower costs. And even Ethereum itself plans to move to a more efficient “Proof of Stake” (PoS) consensus which will reduce energy consumption by over 99%.

What’s Next for NFTs?

NFTs represent one of my favorite areas for investment in 2022. Digital art is valuable in the eye of the beholder, and NFTs make it possible to own a piece of the growing pie.

There’s also an entire, undiscovered world of new NFTs. Jack Dorsey’s original tweet sold for $2.5 million in 2021, 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 could mean safer ways for gamers to sell their efforts to others.

Even physical artwork may one day be 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 go up. 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.