The beginning of this century was gut-check time for investors. Many (myself included) weak-kneed investors watched the S&P 500 lose 50% of its value and the Nasdaq shed nearly 80% of its value. Individuals (such as my father) who thought they'd cashed in on JDS Uniphase (NASDAQ:JDSU) and Hummingbird (NASDAQ:HUMC) in the bull market of the 1990s bailed out, realizing losses as they sold.

Were you one of those panicked investors? Here's a test to find out: Do you remember how much money you made or how much money you ultimately lost? If you remember what you lost, then you also remember the pain.

And painful it was. Years ago, Nobel Prize-winning psychologist Daniel Kahneman and his research partner Amos Tversky found that humans are innately loss-averse, particularly when it comes to money. Kahneman and Tversky's prospect theory research also demonstrated that losses hurt us more emotionally than gains please us -- and that the regret that comes with financial loss can be crippling.

But the solution is not to jump solely into bond funds (even good ones such as Managers Fremont) or index funds such as the Spiders (AMEX:SPY) or Cubes (NASDAQ:QQQQ), which track the S&P 500 and Nasdaq 100, respectively. And the solution is certainly not to bail out of the market altogether. If you do, you're letting great opportunities to build wealth pass you by.

You have the stomach to beat the market. Why am I so sure? Because it is possible to beat the market without assuming huge risk. I know because it's being done.

The special sauce
The secret? Dividends. That's no secret, actually; there is plenty of data that proves dividend-paying stocks outperform non-payers. But that's not the entire truth. To outperform the market, you have to find financially strong, well-managed, undervalued companies that pay dividends. Why take a chance on Joe's Next Generation e-Hot Dog Stand -- with its jumpy beta and 50/50 chance of going bankrupt -- when you could invest in a stable ship that returns profits to shareholders and provides capital returns over the long term? It's a tried-and-true formula, and if you follow it, you'll have the stomach to beat the market.

Mathew Emmert, lead analyst of our Motley Fool Income Investor newsletter service, is a believer in the dividend strategy. Using a combination of outsized yields and capital gains, his picks have beaten the market by more than 5% since inception two years ago. Moreover, 36 of the 44 Income Investor picks have made money for investors. That's 82% accuracy in a field where most are happy batting anything over .500.

With that kind of accuracy, you do have the stomach to beat the market -- and the potential to beat it by a heck of a lot. Take Procter & Gamble (NYSE:PG), for example. At the dawn of the Internet age, your odds of pinpointing Microsoft were about as high as your odds of striking it rich from a scratch-off lotto ticket. But P&G, a stable dividend payer with a 20-year track record, was poised to beat the market without the ups and downs of the dot-com delirium. If you'd put $5,000 in P&G in 1990, that investment would be worth more than $45,000 today. That's a market-crushing 810% return that came without speculating on some unproven company. Don't get me wrong; P&G slid at the beginning of this decade, just like the rest of the market. But because the company kept increasing its dividend, the decline in the stock price just made for a better deal for reinvestment.

Today's income opportunities
Finding great dividend payers isn't as simple as merely screening for yields. As with any investment, it's crucial to scrutinize a dividend payer's financial statements, management team, and business model. Determine how the dividends are being financed, what the payout ratio is and how that might affect future growth, and what the prospects for dividend increases may be. Next, calculate what a share of the company is worth to ensure that your dividends come with the chance at return-enhancing capital gains. This can be hard work, but rest assured that the dividends left standing will reward the patient investor year after year after year.

A poster on our Foolish discussion boards recently asked about selling his solid 10% yield. The stock price had appreciated near his estimate of fair value, and he wondered about the ideal time for him to get out and take his gains. My quick answer: Never. Since he locked in a market-beating yield at a bargain price, he should keep holding on. Why give up an automatic 10% annual return? To date, the Income Investor newsletter sports more than 40 buys and does not yet have a single sell.

That poster's stock is Annaly Mortgage (NYSE:NLY), which was recommended in October 2003 when the stock was trading for $16.15. Mathew estimated its fair value to be $22. The stock currently trades around $19, realizing a 17% capital gain for investors. Not bad in less than two years' time. Moreover, Income Investor subscribers continue to realize at least a 10% annual gain on dividends. That combination really kicks the market to the curb when you note that Annaly is 70% less volatile than the overall market. The chances of wild swings are muted with this solid stock.

Then there's Sonoco (NYSE:SON), which Mathew recommended in May 2004. At the time, the stock was trading for $24. Using a discounted cash flow model, Mathew pegged its fair value closer to $29. Today the stock trades at $26, giving investors a 10% return. Add in the 3.66% yield, and that's good for another market beater. What's more, Sonoco is almost 15% less volatile than the overall market.

The Foolish bottom line
Before investing, you must question your tolerance for risk. Do you have the stomach to watch your savings drop? Don't be ashamed if you don't. You're in the majority. The good news is: You can beat the market without a stomach of steel. Dividends will help you do it.

Join our ship of dividend-loving Fools with a free 30-day trial of Income Investor. There's no obligation to subscribe, and a trial includes access to all back issues and previous picks, mid-month reports, current risk-adjusted values, and the Income Investor discussion boards, where Mathew posts regularly and where you'll find hordes of like-minded investors sharing wisdom, ideas, and analysis. Click here to learn more.

Tim Hanson can stomach a lot of things, but losing money isn't one of them. He does not own shares of any company mentioned in this article. The Motley Fool has a disclosure policy.