Together, some seven years ago now, we watched the beginning of a downturn that cut 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 U.S. history have hurt so much. Sirius Satellite Radio (NASDAQ:SIRI), a bull-market darling, fell from a split-adjusted $65 per share to less than $1 by 2003. And PMC-Sierra (NASDAQ:PMCS) traded from near $250 all the way down to $4.

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. Emotionally, losses hurt us 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. P&G has paid a stable dividend since 1890. Yep, you read that correctly -- the company has paid dividends steadily for the past 117 years. Some of you may be thinking, "Bor-ing!" But over the past 15 years, P&G has returned 14% annually, turning a $10,000 investment into more than $70,000 today. And when stocks like this temporarily decline, owners still get the dividend payment, inspiring all of us to be patient and calm -- two of the primary traits of the world's greatest investors.

Then there's Bank of America (NYSE:BAC), which has raised its dividend in each of the past 30 years. Or AIG (NYSE:AIG), which has increased its dividend 18% on average each year for more than 20 years. Or boring PepsiCo (NYSE:PEP), which has increased its dividend every year since 1972. Bank of America, AIG, and PepsiCo have all outpaced the S&P 500, returning 15%, 14%, and 11% annually over the past 15 years. 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 James Early and his team have beaten the market by nearly 4 percentage points since the newsletter's 2003 inception.

But James 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 save yourself from the market's volatility.

One monster income investment
Finding great dividend payers isn't as simple as merely screening for yields. If it were, everyone would own shares of U.S. Shipping Partners (NYSE:USS) and its 9.4% yield -- which is cyclical and sensitive to demand for oil. 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 James does each month for his members.

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

Income Investor recommended JPMorgan Chase (NYSE:JPM) in August 2005. At the time, the financial giant was trading for $35. Using a discounted cash flow model, we pegged its fair value closer to $45. Today, the stock trades for $44 alongside a 3.4% yield. That's good for an investment that's 7 points ahead of the market.

There are loads of great dividend-paying stocks, but they're not the market's most popular. In fact, you usually have to go digging to find them. But to view James' two newest picks and favorite stocks for new money now, click here. There's no obligation to subscribe, and maybe -- just maybe -- we'll come through this crazy market without any massive losses.

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 does not own shares of any company mentioned in this article. Bank of America is an Income Investor recommendation. No Fool is too cool for disclosure, not even Tim.