Dividend Stocks Beat the Market

There's a good deal of research that shows dividend-paying stocks tend to outperform all other stocks over the long term, and they tend to do so while offering below-average risk to boot. This is why buying and holding solid dividend payers is my preferred method of investing.

Of course, you've probably read a thousand articles that began just like this one, only the words "dividend-paying" were replaced with "small-cap" or "value" or "high-growth." It seems that just about everyone believes in his or her personal investment style -- or at least claims to -- and can conveniently point to some "research" that proves its success.

Whether or not that research happens to be on the back of a cereal box is often left out of the claim, but the result is the same: Folks simply don't know what to believe. What outperforms what? Who outperforms whom?

My research beats your research
Honestly, I don't know that I can completely answer those questions. What I do know, however, is why I believe what I believe, and why you should, too.

I have complete faith in the ability of dividend stocks to outperform the market over time. The research that I've pointed to in my articles over the years is part of that faith, but it's not the whole story. Professor Jeremy Siegel's new book, The Future for Investors, includes vast amounts of market data that support the fact that boring old dividend stocks outperform so-called "growth" stocks over the long term when reinvested dividends are taken into account.

Personally, I think Siegel's market research is the most thoughtful and extensive I've ever seen. He basically removes the effect of factors that have skewed others' research, such as survivorship bias (i.e., the fact that most research only includes companies that are still operating, not those that merged or went bankrupt). In my mind, his results unequivocally prove that dividends -- and their reinvestment over time -- are the key to downright miraculous investment returns.

The need for strategy
But at the end of the day, it's still just research, and investors need more than that. They need specific, real-life examples. A general investment strategy is worth about as much as a barber at a hair plug convention (i.e., not very much). In other words, a strategy only benefits investors if it can be implemented successfully -- in the real world.

Siegel found that an investment in the 10 highest-yielding of the 30 Dow Jones Industrial Average stocks would have returned more than 14% annually from 1957 to 2003, turning a $10,000 investment into nearly $5 million and beating the S&P 500 and Dow 30 indexes. If you wanted to start that strategy today, you'd buy shares of these 10 companies:

That's not a bad collection of companies -- although I'd be wary of General Motors -- and I've even recommended Merck and JPMorgan to my subscribers. But overall, I think you can do better.

That's the reason I began writing the Fool's dividend-stock newsletter, Motley Fool Income Investor, nearly three years ago. I wanted to employ my dividend-focused strategy in plain sight of my readers and use it to make money for them. I wanted to offer specific investments, tell them when to buy, and tell them when to sell.

More than that, I wanted to keep them up-to-date on all past recommendations so nothing would sneak up on them. And most importantly, I wanted to look back at regular intervals and hold myself accountable for my investment performance.

Well, I've been doing all those things for the past three years, and I'm happy to say the results have been good. It seems that our numbers are very much in line with the theory that dividend stocks tend to outperform the market with lower risk.

Overall, the Income Investor portfolio has produced a total return of 17.8% vs. a market return of 14.4%. Readers are also pulling down an average dividend yield of more than 4.7% -- all the while suffering less business and volatility risk. That means the returns are even better on a risk-adjusted basis.

The Foolish bottom line
Fear not: None of that short-term performance is swelling this melon sitting on my shoulders. I'm only as good as my next recommendation, after all. But I believe the brightest days for our strategy lie ahead.

With relatively high market valuations, slowing earnings growth, rising interest rates, and oil prices floating around $70 per barrel, the current bull market could be in jeopardy. That's the bad news.

The good news: Dividend investors are supposed to do particularly well in this kind of market -- and I believe we're going to do just that. If you'd like to learn more, click here to be my guest at Income Investor free for 30 days.

One should never be overconfident, but there are reasons to be hopeful about our future.

This commentary was originally published on Aug. 22, 2005. It has been updated.

Mathew Emmert likes to outperform, but he doesn't look down his nose at those who don't. Live and let live, ya know? He owns shares of Altria and Merck. In case you missed the 40 times he mentioned it in this article, he's also the chief analyst of Motley Fool Income Investor . Pfizer and Coca-Cola are Motley Fool Inside Value recommendations. The Fool has a disclosure policy.