The Art Market Shows How NFTs May Work Out As Investments

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CryptoPunk digital art non-fungible token (NFT) displayed on a digital billboard in Times Square on May 12, 2021 in New York City. The image is part of SaveArtSpace’s “Pixelated” public art exhibition which will be displaying 193 of Larva Labs’ CryptoPunks on phone booths, bus shelters, and billboards around New York City during the month of May. New York Governor Andrew Cuomo announced pandemic restrictions to be lifted on May 19. (Photo by Alexi Rosenfeld/Getty Images)

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NFTs, or non-fungible tokens, are an emerging technology trend. Will they prove good investments? The art market offers some clues.

What Are NFTs Anyway?

Blockchain technology can verify ownership of digital and physical assets. Specifically EIP-721 has been broadly used for this purpose. You can prove ownership of anything (not just cryptocurrency) via the blockchain. That’s important. Most people would only want to play large amounts of money for something if they can prove ownership.

Lindy Effect

Now, this NFT trend may seem precarious. Pessimists may argue that something will break with this process in future. It may. However, the history of cryptocurrencies and the so-called Lindy effect suggests that the technology may prove robust. The longer a technology lasts, the longer we might expect it to remain. NFTs have a short history of just a few years, but Bitcoin has now lasted two decades. Hence the technology looks set to remain and evolve, even if valuations can be debated.

What The Art Market Tells Us

The long-term history of the art market suggests that there may be a future for some NFTs since, for now, the NFTs look closest to the art market. However, there are some big caveats too. A detailed analysis of the history of the art market by Rachel Pownall at Tilburg University shows that the returns to art have been about 7% a year over the 1980 to 2006 period.

It’s important to note that’s an average and returns to art have varied, being quite strong in the 1980s, generally weaker in the 1990s, with prices often declining, and more robust in the 2000s.

Maybe that’s a reason to be optimistic about NFTs if they are indeed fine art, perhaps returns may be similar.

Dead Artists And Scarcity

A crucial economic principle is that of scarcity. Water or oxygen may be necessary for life and therefore essential, but they don’t command high prices as they are abundant.

Certain cryptocurrencies have performed well, in part, because their supply is limited by design. Looking at art, the the works of Matisse are highly valued, but he died in 1954. Hence there won’t be any new Matisse paintings.

Indeed, most of the value of the art market consists of dead artists.

This is an issue for NFTs. Of course, they don’t plan to produce any more CryptoPunks beyond the 10,000 that are out there. Still, Larva Labs, who produced the CryptoPunks have also produced 20,000 Meebits. Then there are Super Yetis, CyberKongz, DeadHeads, Voxies and the Bored Ape Yacht Club. The list goes on. Mike Winkelmann, a leading NFT artist, is very much alive at 40 years old. He’s unlikely to stop producing.

The point is that because NFTs are successful, others are getting in on the action. Supply is increasing. It’s classic economics. That’s seldom good for retaining value. In addition to scarcity, we have second crucial point, selection bias.

Selection Bias

Even the average 7% annual return to art, as a rough number, may well be overstated. The reason is we have much better data on auction valuations than less glamorous and more routine dealer transactions.

The Quality Bar

Only art passing a quality bar makes it to auction. If something is found to be a fraud or its value declines in some other way, chances are it won’t be up for auction. If we’re just tracking the winners and seeing a 7% return, the return for the average person buying art may be quite a bit lower. Maybe they pick the wrong artist, or maybe an artist falls out of favor.

The auction houses chose what art to sell. That’s part of their usefulness and their criteria evolve over time. Indeed, some auction houses now sell NFTs, but of course only the more successful ones.

Tracking Winners

So art indices that track auction house valuations, because that’s where the good data is, likely overstate returns to art in general by just looking at the long-term winners. John Constable was certainly not the only British artist in the 1800s, but he’s one of only a few we still hear about.

This is a big issue for NFTs. Yes CyperPunks have done well for many holders with CryptoPunk #3100 selling for over $7 million in March 2021. But launching in 2017, this was among the earlier NFT projects. A lot of other NFT projects get a lot less attention and a worth far less. Importantly, a lot more NFTs are likely coming in the years ahead.

So maybe certain NFTs that stand the test of time may make sense as a long-term investment, much like fine art. However, surging supply does not bode well. Investing in NFTs may look easy in retrospect, because we’ll continue to talk about the winning projects and forget the others. In that way, investing in NFTs may be a lot like investing in art.

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Simon provides an outsourced Chief Investment Officer service to institutional investors. He has previously served as Chief Investment Officer at Moola and FutureAdvisor, both are consumer investment startups that were subsequently acquired by S&P 500 firms. He has published two books and is a CFA Charterholder and educated at Oxford and Northwestern. Articles are informational only, not investment advice.