What Are NFTs? A Guide for Investors

Most investors probably didn’t hear about non-fungible tokens until last year. That’s when NFTs exploded onto the scene, mostly in the form of digital art.

Sales hit a monthly record near $5 billion in August 2021, according to numbers from industry data aggregator CryptoSlam. Sales continued in the billions before falling steeply this June along with the value of cryptocurrencies, which are often used to purchase these tokens.

Like cryptocurrencies, NFTs are authenticated with blockchain technology. But unlike, say, Bitcoin (BTC), NFTs represent ownership in something specific, like a digital painting. While NFTs can be bought and sold in a similar way that a sculpture might be auctioned, they can’t be exchanged for goods and services in the same manner as cryptocurrencies like Bitcoin.

When it comes to investing, the market for NFTs is far from mature. Any but the most speculative of investors may want to steer clear until the regulatory haze dissipates and more real-world uses for NFTs are developed. In the meantime, you may want to consider them as something fun to collect that, like a stamp collection, might end up being worth something one day.

“Their true value lies in their underlying utility and the fact that they represent ownership,” says Anthony Georgiades, general partner with technology venture capital firm Innovating Capital. “There are so many useful future applications of the technology that will have practical implications for businesses and consumers.”

The following are some factors for investors to keep in mind as they explore the ins and outs of NFTs:

— What are NFTs, and how do they work?

— NFTs and art.

— Risks of NFTs as investments.

— Regulatory risk.

— Investing case may improve as use cases proliferate.

— Bottom line: Should you buy NFTs?

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What are NFTs, and How Do They Work?

NFTs are media files attached to a specific digital token that can be tracked and verified on a blockchain, explains Jeff Davis, founder of Cap3 Collective, an organization launching later this month that will fund blockchain-based web projects.

“In the most basic terms, NFTs are the mechanism that facilitates verifiable ownership of digital property,” says Walker Holmes, vice president of metaverse platform MetaTope. “As we continue to evolve into a more digital world, we will see deeds, titles, tickets, ID cards, and so much more represented by NFTs and verified on the blockchain.”

Created with smart contracts that assign ownership and allow transfers, NFTs are bought and sold in online marketplaces, with some platforms allowing fractional ownership — useful as tokens can cost tens of thousands of dollars apiece.

NFTs and Art

Digital artwork is just one use case for NFTs, but it’s been a popular one, creating a more democratic model for selling art.

“Art galleries and auction houses have been the market makers of the art world — where museums, collectors and artists go to buy and sell art,” says Sarah McDaniel, head of Morgan Stanley Wealth Management’s art resources team. “NFTs and their marketplaces disrupt this process by allowing more artists to go straight to market and sell directly to buyers.”

These tokens can also make it easier for artists to earn royalties each time their art is sold.

But artists shouldn’t expect blockbuster earnings just because they release an NFT, says Richard Gardner, CEO of Modulus Global, which provides financial software to brokerages and professional traders.

“Especially given the current economic climate and downward trend of the NFT market, you can’t seriously expect to monetize to the tune of six figures unless you’re bringing your own star power to the table,” he says.

Because NFTs are often bought and sold with cryptocurrencies, volatility there can bleed over into non-fungible tokens. For example, if you bought a piece of digital art using one unit of Ether (ETH), the currency of the Ethereum network, in mid-March at the exchange rate then, about $3,500, the same art on Monday would be worth less than $2,000, assuming no other changes than those in the exchange rate.

Of course, there are other reasons for buying art than investment purposes, so concern about cryptocurrency volatility may be moot for you.

[READ: How to Invest in Art.]

Risks of NFTs as Investments

But for investors, that and other influences come to bear.

The first thing people who want to buy NFTs should know is that this type of investing is highly speculative, meaning it is risky, according to Grant Powell, founder of Curios, an NFT-as-a-service platform.

Risks with NFT investing include copycat NFTs posing as popular tokens or fraudulent sites that try to entice potential buyers to connect their wallets to steal cryptocurrency and NFTs, says Stephen Sikes, chief operating officer of investing platform Public.com.

“Look for verified sellers on marketplaces to avoid scams,” Sikes says.

There is the risk that even reputable NFT marketplaces can get hacked. Omer Amsel, director of product management with digital asset security platform Fireblocks, recommends transferring purchased NFTs into secure wallets unless you’re flipping the tokens quickly.

Investors should educate themselves on how and where to buy NFTs, the track record and star power of their creators prior to an NFT project, how to verify ownership, and how to keep a wallet secure. Tools and steps for making safe purchases include checking whether the marketplaces are partnered with any security protocols, researching NFT creators or sellers, being wary of solicitors requesting private information, checking previous transactions or utilizing specific technological solutions that can assess the rareness of an NFT.

“Spend a good month just learning best practices and getting a lay of the land before you spend a penny,” Davis says.

Joshua Hong, founder of blockchain-based web application Synesis One, says the most important aspect of investing in NFTs is also the most challenging: analyzing the utility and the community behind a particular token.

One reason why it’s so important to research who’s behind an NFT project is that the market value of an NFT is usually determined by the close ties and interactions between creators, supporters, fans, buyers and sellers, Hong says.

In other words, community is important when thinking about investing in NFTs.

“Strong communities drive a lot of value when it comes to NFTs,” Amsel says. “Blue-chip projects like Doodles, Cool Cats, Apes and Art Blocks have massive followings. These are the types of projects people are excited by, and it’s not just the HODLers who are excited, but also large VC funds as we continue to see institutional money flow into the space.”

Long-term crypto investors who “hold on for dear life,” or HODLers, believe cryptocurrency will eventually replace the current monetary system and plan to buy and hold indefinitely. Others follow a strategy of diversification similar to the one they use with their traditional investment portfolio.

If you do decide to invest, spend only what you can afford to lose, choose an approach that suits your investment style and stick with it.

“Some people only invest in NFTs with long-term utility and plan to hold for years, while others buy a hot art project today and will look to flip tomorrow for a quick profit,” Davis says.

[Read: How to Invest in Cryptocurrency.]

Regulatory Risk

There is one sort of risk that deserves its own section: regulatory risk. While NFTs have much in common with stocks, they haven’t officially been declared securities, and they may end up being considered commodities.

“The market in the U.S. continues to try to guess what the regulation is by paying expensive lawyers to interpret the 80-plus (crypto) enforcement actions that have taken place by the Securities and Exchange Commission so far,” says Arry Yu, chair of the Washington Technology Industry Association’s Cascadia Blockchain Council.

Gardner cautions against entering the NFT market right now because the regulatory environment of digital assets is in flux.

“Forthcoming rules could very well change how the industry operates over the next 12 to 24 months,” he says.

Investing Case May Improve as Use Cases Proliferate

While most NFTs today are linked to digital art, the future of these types of tokens lies in their utility as financial assets that can provide passive income or the right to participate in a membership or a deed, Hong says.

“NFTs are the future,” says Reeve Collins, co-founder of NFT platform BLOCKv. “There will be many applications for them, and they will be an integral part of our digital lives.”

But for now, Collins argues that the early NFTs without real utility should be viewed as collectibles rather than investments. Instead, he recommends investing in companies building NFT technology.

“This first NFT boom was all about speculation and gambling, buying an asset low, hoping for appreciation and selling it,” he says. “While that is a lot of fun, and at times even addicting, in my opinion it is not investing. Picking which image to invest in at the moment should only be done for entertainment versus a goal of long-term asset appreciation.”

Bottom Line: Should You Buy NFTs?

Yes and no. Yes, if you want to have a fun collectible hobby. No — or at least not yet — if you want to do anything but highly speculative investing.

If you’re into the latter, perhaps consider setting aside a small portion of your portfolio for NFT investing in a similar way in which you might think about penny stocks.

“Ultimately, similar to the advice art advisors give their clients, it’s important to buy what you love and what gets you excited,” Amsel says. “Find a community of creators you believe in and support them. Stay the course over time, keep an ear to the ground, and you may find yourself with a quite valuable NFT collection as a result.”

More from U.S. News

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What Are NFTs? A Guide for Investors originally appeared on usnews.com

Update 08/16/22: This story was published at an earlier date and has been updated with new information.

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