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Investing in NFTs: Why It Matters

May 25, 2021

By Evan Cohen, Co-Founder, Vincent

As investors increasingly expand their portfolios into the world of digital finance, one theme which continues to draw interest is the development of digitally native goods. These are goods or items that are created and utilized primarily in a digital environment, meaning their primary use case plays out on a computer or smartphone. It’s no secret that the world is moving into a digital economy, and thus digitally native goods represent a logical step in building products or services for digital-first experiences such as web platforms, video games, or even software products. Early examples of digital goods include eBooks or iTunes songs, which primarily were digital representations of physical goods (books, records…) created to expand distribution to a wider audience over the internet.

Digital goods were essential in creating mass adoption for digital interfaces such as laptops, e-readers, and mp3 players, but in parallel created serious copyright headaches given the ease of unregulated sharing and copying. Many investors have a negative perception of digital goods, recalling the early days of Napster and media pirating—which decimated the music industry’s profitability. But in reality, the crux of the challenges with these digital goods was not their digital environment as much as their lack of uniqueness which commoditized their value. The cost of buying a CD was $10, but the cost of making a copy was effectively $0—meaning there was no incentive for people not to share.

Interestingly though, at the same time Napster and RIAA battled it out over copyright infringement, unique digital goods were taking off in another area of the digital world: domain names. Domain name marketplaces exploded in the early 2000s, as early investors recognized that the uniqueness of each domain created scarcity, which in turn could create asset appreciation should the internet market grow (hint: it did). Investors who got in early on domain names became multi-millionaires, and many are at it again today with the latest advent in digital goods, NFTs. NFTs, or non-fungible tokens, are the latest technological development in digitally native goods. Over the last year, billions of dollars have been deployed into NFTs as investors look to capture the next ‘domain name’ wealth. But unlike domain names, the technology behind NFTs offer a much greater opportunity for digital goods, as they represent a tool to allow the creation and deployment of digitally native goods by anyone on Earth. Today, my father can go online and generate a unique digitally native good with just a few clicks, capturing that same value as creating a domain name. And there is a literal universe of creative possibilities for NFTs, as many as our minds can imagine, as opposed to the expansive though finite name space of the early Internet.

What are NFTs? Non-fungible tokens (NFTs) are digitally native goods or items which are created and managed on a blockchain. A blockchain is a digital ledger, which effectively acts as a database for tracking and (in this case NFT) management. When someone wants to create an NFT, they ‘mint’ it on a blockchain, which allows all other people to recognize its creation and view its ownership. Think about it like a digital phone book, where anyone can publish their number and have it verified by the phone company. The blockchain operates similarly, except instead of the phone company verifying the NFT, the blockchain network does. Like a phone number in the phone book, once an NFT is minted it cannot be copied or replicated. It’s one-of-a-kind, and its ownership will always be documented on the blockchain. If you change your phone number, you tell the phone company and they update the book. If you transfer or sell your NFT, the blockchain will update and notate the new owner. NFTs use blockchains because they are cryptographically secure. This means they are incredibly difficult to hack, alter or change—which means your NFT ownership is secure.

NFTs are not cryptocurrency One common misperception is that NFTs are a form of cryptocurrency because they both run on blockchains. This is like saying a LeBron James trading card is the same as a $20 bill. Just because both are printed on paper does not mean they are the same. Crypto coins are like paper money. Each dollar bill is exactly the same value and can be swapped out at random. Your $20 bill is the same value as mine. Your Bitcoin is the same value as my Bitcoin. If we traded bills, they’d be worth the exact same thing. As tokens, they are fungible. NFTs are different because they are minted uniquely, similar to a painting or trading card. Oftentimes cards will have a print number, indicating the uniqueness of the set. Like how the Michael Jordan rookie card is #25/500, an NFT can be the same. We may have similar cards, but your print number is different and thus can represent a different value on the market.

Investing in NFTs The simplest way to think about an NFT is to consider it a digital collectible. Most investors are familiar with collectibles such as artwork, fine wine, trading cards, or even classic cars. Often these assets can make great investments, as they appreciate in value over time and their valuations tend to not correlate with other investment markets. Their appreciating value is often derived by two factors: their creator and their scarcity. Before investing in any collectible, it’s essential to understand who created the asset and how many were created. Also, it’s important to confirm the authenticity of the item, as these markets tend to be unregulated and thus are full of forgeries. Investing in NFTs, or digital collectibles, is arguably the same process.

Whether it’s digital art, digital trading cards, or even albums, investors must ask the same who and how many questions to help determine the proper valuation. That said, unlike real-world collectibles the authenticity is a given, as the blockchain will provide a full ownership history since the item was minted. This definitely can help speed up the process for investors looking to transact quickly. If you’re investing in collectibles, whether physical or digital, it’s important to understand valuations are highly speculative. For example, why one painting is worth $50 and another worth $50M is highly uncorrelated. Collectors often purchase assets for intrinsic value outside of the investment scope, which can create challenges when trying to properly evaluate an asset. If you love the painter or athlete, you may be willing to overpay to own the asset. This can present challenges when you’re looking to buy—but at the same time could be highly beneficial when selling. Either way, when investing in collectibles it’s best to have a long time horizon, as the long-term appreciation tends to be a safer bet.

Understanding today’s NFT market The NFT world is a burgeoning new market, and with any new market comes incredible opportunity and risk. On the supply side, creators are coming from all over the world to mint new unique collectibles and sell them online. On the demand side, similar to the domain name craze, early-adopter investors are jumping in hoping to catch the wave before NFTs become mainstream. Billions to date have already been deployed into NFTs, and we’re just in the early innings. The technological infrastructure to mint, host, and trade NFTs is still being developed, while marketplaces are just coming online to help buyers and sellers connect. Creators and artists are still familiarizing themselves with the format and process of creating digitally native goods, but it’s growing quickly and becoming more mainstream each month. One challenge with NFTs today is their reliance on Ethereum, a popular blockchain that hosts many NFT projects. Ethereum’s growth and popularity has created scaling issues on its network, which at times can create slowness as well as high transaction fees. Ethereum has proposed network upgrades to ease congestion, which should help NFTs become more affordable. In parallel, Ethereum competitors such as Flow, Near, and Polkadot are all rushing to become the de-facto NFT blockchain given their already scaled solutions. It’s unclear today which blockchain will win, or if the market is even a winner-take-all. But as you determine which NFT to invest into, be sure to understand which blockchain the item was minted on.

A second challenge is managing custody, as these are digitally native goods which live on a blockchain. To invest in an NFT means you’ll be owning a digital good, and this good will need to be housed in the digital wallet of the blockchain being used. Ethereum NFTs need Ethereum wallets, Flow NFTs need Flow wallets, and so on. Blockchain wallets are highly stable and easy to use, but they are only as secure as you make them. So, if you’re hosting valuable assets in a wallet, be sure to take the necessary precautions to secure the password and private key. Lost wallets cannot be recovered, and if hacked they cannot be retrievable. So taking security seriously is important—just as you would any physical collectible.

Lastly, with the market being so new and bullish investors rushing in quickly, valuations for certain NFTs have exploded. Like any collectible, these values are highly speculative and when markets are hot that speculation can run rampant. An important factor to always remember is that collectible valuations are derived primarily by the who and how many—not by format. A Picasso painting with oil on canvas may be worth just as much as a Picasso drawn with pencil on paper. The medium is a small factor in determining the valuation of a collectible, so as you evaluate NFTs, don’t invest in them because they are NFTs. Invest because you believe the asset itself will appreciate. As noted, collectible appreciation should be viewed as a long-term approach, and as NFTs become mainstream the hype around the technology will fade. Focus on the asset, not the vehicle.

About the Author Evan Cohen is co-founder of Vincent, the largest search engine for alternative asset investing. A seasoned investor, Evan previously served as head of investing at Indiegogo, as well as a partner at HCVC, a global early-stage venture capital fund.