Beat the Market With Less Risk

This article has been updated since its initial publication on Dec. 1, 2003.

There's no question that dividend-paying stocks have been less volatile (read: less risky) than their stingier brethren over the years. In fact, they tend to contribute little more than 10% of the volatility of the market as a whole while producing market-beating returns. What's this? You mean you can get better returns with lower risk just by purchasing dividend-paying stocks? You betcha.

The standard line in relation to investment risk is that those who take on more risk are destined to receive more reward. While this is largely true, it's only true to a certain extent. We as investors have a tendency to dramatically overestimate the amount of risk that's required to achieve respectable returns.

Indeed, at a certain point, each incremental unit of risk that you take actually produces a smaller amount of return. This is largely because, as you start to swim deeper and deeper into the risk pool, you have fewer winners and more failures affecting your overall success rate.

Unfortunately, there's no magic number that tells us when the additional return is no longer worth the risk. So, ultimately, we have to learn where that cutoff lies for us as individuals in order to maximize returns for the amount of risk that we're willing to take.

However, in investing it is often possible to dramatically increase our returns while reducing our risk by seeking companies that possess certain characteristics. And, to that end, it turns out that whether a company pays a dividend is a rather important characteristic.

The real deal
Do you need proof in order to believe that you can actually receive greater returns while taking on less risk just by investing in dividend-paying stocks? Well, BusinessWeek has pointed out that the return of the Nasdaq stock market, known for its healthy dose of aggressive technology stocks, actually underperformed the S&P Utility Stock Index from 1971 through the third quarter of 2001 -- 11.2% vs. 12%, including dividends.

Granted, the actual difference in return is modest, but the real importance here lies in the fact that the utility investors took on substantially less risk to achieve their return, making the difference on a risk-adjusted basis much more meaningful.

Indeed, the utility index beat the Nasdaq while incurring about half its volatility. The bottom line: During this period, Nasdaq investors were not adequately compensated for the amount of risk they took on, so don't take unnecessary risks in your portfolio. In the end, one could have achieved a higher total return, experienced far less price fluctuation, and maintained a substantially higher level of income by owning the boring, old utility index.

Several other studies bear out what we've seen here. Dividends have contributed 42% of the S&P 500's total return since 1926. That's right -- when it comes to that 10.2% S&P 500 return figure that everyone tosses around, nearly half of it came from dividends.

The income answer
I'm not saying that every stock in your portfolio has to be a utility or a dividend stock -- far from it. However, investors must always be conscious of the level of risk that they're taking to achieve their reward, and historically speaking, dividend-paying investments have offered the most compelling risk-reward trade-off available. Opportunities to achieve above-average returns while taking below-average risk abound in this investment category.

For instance, the best-performing investment selection for Motley Fool Income Investor has been Annaly Mortgage (NYSE: NLY  ) . This company has returned 19.14% to our readers over the past six months, handily beating the 5.3% of its benchmark. Despite its increase, the firm still boasts a yield approaching 11%. The real story here, however, is that the company has produced its market-beating return while being only one-third as volatile as the overall market. So, again, on a risk-adjusted basis the return is much more favorable.

The same can be said for all of the newsletter selections thus far, as well as the stocks selected for the income-producing Six-Pack Portfolio on Fool.com back in March of last year. Overall, Income Investor selections are doing 10.4% better than the market while being only 10% as volatile as their benchmarks.

The Six-Pack Portfolio, including investments such as BellSouth (NYSE: BLS  ) , ConAgra Foods (NYSE: CAG  ) , and Altria (NYSE: MO  ) , has produced a total return of 45.5%, comfortably beating the S&P's 35.22%, and again, the Six-Pack has been just half as volatile as the overall market. I continue to favor this portfolio, and believe these companies will march higher in the years to come while producing substantial dividends for income-oriented investors.

Another important aspect of the income-investing strategy is that dividend payers tend to fall only half as much as non-payers in down markets, as they have their yield to help support the shares. There are a great many people who were wishing they had a few dividend payers in their portfolios when the bears came calling. If you and your stomach endured the wild rides of a Cisco Systems (Nasdaq: CSCO  ) or an Amazon.com (Nasdaq: AMZN  ) in the late 1990s, think about how much money you'll save on Maalox consumption once you're in solid, dividend-paying companies.

The Foolish bottom line
Identifying one's risk tolerance is a difficult process. Can I truly stomach the volatility of my investments? Am I OK with the idea that I could actually lose money? Can I survive that Mariah Carey concert? But the good news is that there's an entire investment approach that can keep you in the shallow end of the risk pool without drowning you in underperformance. Join the income investors (in fact, right now you can take a free trial) and fall asleep when your head hits the pillow.

Mathew Emmert'sIncome Investornewsletter is published by The Motley Fool. Mathew owns shares in Altria, AmSouth Bancorp, Annaly Mortgage, other companies that start with the letter "A," and BellSouth. The Fool has an investor-friendlydisclosure policy.


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