Together, five years ago, we watched the beginning of a downturn that knocked the S&P 500 in half and dropped the Nasdaq nearly 80% off its highs. It was a maddening time for investors. Telecom and energy executives were caught with their hands in the corporate cookie jar. Technology shares plummeted, with hundreds of companies vanishing from sight. Very few bear markets in American history hurt as much. Sun Microsystems (NASDAQ:SUNW), a bull market darling, has fallen from $63 per share to $4 today. And Cisco Systems (NASDAQ:CSCO) traded from north of $80 to below $20.

Just how painful was it? Ask Nobel Prize-winning psychologist Daniel Kahneman, who proved that humans are innately loss-averse, particularly when it comes to money. Losses hurt us emotionally far more than gains give us pleasure. Naturally then, those 50% to 80% declines crippled tens of thousands of investors, many of whom will -- sadly -- never throw the one-two punch of savings and investment again.

It doesn't have to be that way.

Win with moderate risk
The solution is not to bail out of the market altogether, nor to seek shelter exclusively in bond funds. With the right perspective and useful tools, you can strengthen your stomach and beat the market -- because you'll do so without assuming huge risk. I know that's true because it's being done every year by the world's master investors -- from Buffett to Lynch to Tillinghast to Miller.

Those who take the biggest risks and buy what's hot today usually take the biggest hits in down markets. In the meantime, a host of methodical, smart, and contrarian investors ring up great returns, even through tough markets, by adhering to Warren Buffett's first rule of investing: Preserve capital.

Today, I want to focus on one sweet way to preserve capital and beat the market. The general principle is simple: Buy stocks that have paid uninterrupted dividends for years.

Consistency to victory
Let's investigate this idea by looking first at Procter & Gamble. P&G has paid a stable dividend since 1890. Yep, you read that correctly -- the company has paid dividends steadily for the past 115 years. Some of you may be thinking, "Boring!" But over the past 15 years, P&G has risen nine times in value, turning a $20,000 investment into $180,000 today. And when stocks like this temporarily decline, owners still get the dividend payment, inspiring them to be patient and calm (two of the primary traits of the world's greatest investors). Then there's Colgate-Palmolive (NYSE:CL), which has paid a dividend since 1895 and has increased its dividend in each of the past 42 years. Or Pfizer (NYSE:PFE), which has paid a dividend since 1938 and has increased its dividend in each of the past 38 years. Since 1990, both Colgate and Pfizer have more than doubled the return of the S&P 500.

This sort of investing is happening every day in our Motley Fool Income Investor advisory service. Using a combination of outsized yields and capital gains, analyst Mathew Emmert has beaten the market by nearly seven percentage points since inception two years ago. Moreover, 38 of the 46 Income Investor picks have made money for investors. That's 83% accuracy in a field where most are happy batting anything over .500.

But Emmert isn't picking just any old high-yielder. He believes that 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, battered balance sheet, and a 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.

Two monster income investments
Finding great dividend payers isn't as simple as merely screening for yields. If it were, everyone and their brother would own shares of Nordic American Tanker Shipping (NYSE:NAT) and its 10% yield. 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. This is exactly what Mathew does each month for his members.

Let's look at two of his favorite monster stocks:

Health Care REIT (NYSE:HCN) was recommended in September 2003 when the stock was trading for $30 per share. Mathew estimated its fair value to be $41. The stock currently trades around $38.50, realizing a 28% capital gain for investors. But now factor in the 7% annual gain from dividends that subscribers locked in! The stock is up more than 35% vs. a market gain during that period of 18%. Furthermore, Health Care REIT is 70% less volatile than the general market. It's a steady yet substantial winner that still trades at an almost 10% discount to its fair value.

Then there's Dow Chemical (NYSE:DOW), which Mathew recommended in March 2004. At the time, the stock was trading for $39. Using a discounted cash flow model, Mathew pegged its fair value closer to $54. Today the stock trades just above $47, giving investors a 20% return. Add the 3% yield and this stock is 15 percentage points ahead of the market -- with more upside available.

There are loads of great dividend payers in America, but they're not the market's hottest stocks. To view Emmert's almost four dozen favorite income stocks, join the 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.

This article was originally published as "Do You Have the Stomach to Beat the Market?" on June 10, 2005. It has been updated.

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. Pfizer and Colgate-Palmolive are Motley Fool Inside Value recommendations. The Motley Fool has adisclosure policy.