What are NFTs? Here's everything you need to know

NFTs explained
(Image credit: Shutterstock)

Lately, it seems like you can’t swing a bored ape without hitting a the front page of Technology news, an awkward celebrity interviewor a Twitter flame war about NFTs. 

Whether you’re all in on NFTs or wish everyone would stop talking about them, it’s pretty clear that these new investments aren’t just a flash in the pan. So it’s worthwhile to understand precisely what these tokens are and how they work. Here’s what you need to know about NFTs.

What is an NFT?

NFT stands for non-fungible token. They're are a type of crypto asset, meaning they are digital assets rather than physical. Also, while they can hold monetary value like any other asset, they are not considered a cryptocurrency.

Non-fungible refers to the fact that each NFT is unique. If you have ever taken an economics class, you may remember that “fungible” means mutually interchangeable. For instance, you can exchange a $20 bill for two $5 bills and a $10 bill and have the exact same amount of money.

Cryptocurrency is also fungible. If you have one Ethereum coin, you can exchange it for any other Ethereum coin.

NFTs aren't mutually interchangeable. In that way, they’re similar to trading cards. For instance, if you have a Nolan Ryan rookie card and your friend has a Cal Ripken 2131 card, you may both have valuable baseball cards, but they aren't the same.

In other words, NFTs are digital assets that offer exclusive ownership to one person. 

While copying an NFT's digital file is always possible, the NFT itself offers proof of ownership of the asset, which can't be duplicated. This makes it similar to fine art investing. For instance, Van Gogh's Starry Night can only have one owner (MoMA), even though the image has hundreds of thousands of reproductions.

What are NFTs used for?

NFTs help to solve a problem for artists and creators in the modern age. Specifically, though creating digital assets allows artists to reach a global audience, the fact that digital assets are easily shared makes it much more difficult for the creators to earn money from their creations. 

The NFT model combines the best of both worlds: the wide-reaching benefits of the internet plus the financial stake of ownership of the physical world. 

Artists can use NFTs as a way to sell their art and grow their platform at once–and buyers can purchase NFTs from their favorite artists to support them.

How do NFTs work?

To make an NFT, the creator will tie their digital file to a unique token on the blockchain. The blockchain is a decentralized data storage system that anyone can add to, but no one can change–which no person, company, or government is in charge of. 

That ensures the data in the blockchain is spread out and virtually impossible to change, so it provides proof of any transactions on the blockchain that have come before.

Most NFTs are stored on the Ethereum blockchain, although other blockchains have also gotten into the game and created their own versions of NFTs.

Why do people invest in NFTs?

There are several reasons why NFT collectors choose to invest in these assets:

  • Supporting artists: Purchasing an artist’s NFT is a way to help them make money from digital assets, which can be challenging to monetize. In addition, many early NFT adopters were the fine art community members who saw this innovation as a new way of investing in art and artists.
  • Joining a community: Ownership of an NFT gives buyers access to a community of other buyers. Some NFT holders love the sense of being a part of an emerging community.
  • Symbolizing status: Like a Rolex watch, an NFT is an expensive and discretionary purchase.
  • Speculative investing: According to NFT enthusiasts, the value increases even when non-NFT holders use and distribute the digital art that is the basis of the NFT. That’s because the more well-known the image or asset becomes, the more value that renowned piece confers on the NFT itself.

What are the downsides of NFTs?

NFTs offer exciting opportunities but also some troubling downsides to this type of investment.

Environmental concerns

NFTs, like cryptocurrency, reside on the blockchain, which uses a system called proof of work to verify the accuracy of transactions. This system requires a lot of computing power, which uses up a great deal of energy. 

According to a 2019 finding by the University of Cambridge, Bitcoin’s blockchain (which is only one of many cryptocurrency blockchains) uses as much energy in one year as the entire country of Switzerland.

As of 2019, 63.3% of global electricity was generated using fossil fuels. Using electricity for non-essential purposes, like the blockchains on which NFTs reside, could be considered an unreasonable demand on our resources.

NFTs are speculative

Similar to the housing bubble, the dot-com bubble, and even the Beanie Baby craze, there is an aspect of “irrational exuberance” to the current interest in NFTs. Like those that came before it, this investment is often touted as a sure thing that can only go up. 

And since many people don’t understand the mechanics behind what an NFT is and how it works, they are vulnerable to investing without doing their due diligence.

The recent fluctuations in the NFT market have made it clear that there is nothing “sure” about NFTs and that even those who understand how this innovation works may not be happy with their investment.

Potential for hacking

Though one of the selling points of NFTs is the fact that it's very difficult to "steal" something from the blockchain, that doesn't mean these assets can't be hacked. There are vulnerabilities within the blockchain that hackers can and have exploited.

You are also vulnerable to more human foibles, such as the ever-present danger posed by phishing, which is the source of most data breaches. 

Additionally, there have been stories of buyers forgetting the password of their crypto wallets and thereby losing access to their assets. 

Should you invest in NFTs?

Deciding if an NFT fits your investment strategy depends on your risk tolerance, your comfort with emerging technologies, and the amount of money you’re comfortable losing.

Make sure you don’t invest any money you can’t afford to lose, and do your research before you buy. Seemingly exciting new NFT investments should especially prompt you to look before you leap.

Emily Guy Birken
Personal finance writer

Emily Guy Birken is a former educator, lifelong money nerd, and a Plutus Award-winning freelance writer who specializes in the scientific research behind irrational money behaviors. Her background in education allows her to make complex financial topics relatable and easily understood by the layperson. Her work has appeared on The Huffington Post, Business Insider, Kiplinger's, MSN Money, and The Washington Post online. She is the author of several books, including The 5 Years Before You Retire, End Financial Stress Now, and the brand new book Stacked: Your Super Serious Guide to Modern Money Management, written with Joe Saul-Sehy.

Emily lives in Milwaukee with her family.