Together, six 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 so much. JDS Uniphase (NASDAQ:JDSU), a bull-market darling, has fallen from a split-adjusted $140 per share to $3 today. And Lucent (NYSE:LU) traded from north of $50 down to that same $3 level today.

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 massive 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 (NYSE:PG). P&G has paid a stable dividend since 1890. Yep, you read that correctly -- the company has paid dividends steadily for the past 116 years. Some of you may be thinking, "Boring!" But over the past 15 years, P&G has grown to nine times its original 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. (And patience and calm are two of the primary traits of the world's greatest investors.) Then there's First Indiana (NASDAQ:FINB), which has paid an uninterrupted dividend for nearly 20 years and raised it in each of the past 14. Or Progress Energy (NYSE:PGN), which has raised its dividend for 18 straight years. Since 1990, First Indiana has posted total annualized gains of 18%, and Progress Energy 9.8% -- both outrunning the market's return of 8.3% over the same time frame.

This sort of investing success 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 three percentage points since his newsletter's inception more than two years ago.

But Mathew 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 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 would own shares of Fedders (NYSE:FJC) and its greater-than-7% yield (a yield that no longer exists, even though it's still advertised on quote feeds). 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 one of his favorite monster stocks:

Mathew recommended Sonoco (NYSE:SON) in May 2004. At the time, the stock was trading for $24. Using his discounted cash flow model, Mathew pegged its fair value closer to $29. Today the stock trades at $31, a 28% return for investors. Add the 3.66% yield subscribers have locked in, and that's good for an investment that's 11 points ahead of the market. What's more, Sonoco is almost 15% less volatile than the overall market.

There are loads of great dividend-payers in America, but they're not the market's hottest stocks. To view Mathew'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 you'll find regular posts from Mathew and 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. The Motley Fool has a d isclosure policy.