Together, seven years ago, we watched the beginning of a downturn that cut the S&P 500 in half and dropped the Nasdaq nearly 80% from 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 going bust. Very few bear markets in U.S. history have hurt so much. Sun Microsystems (NASDAQ:JAVA), a bull-market darling, has fallen from $60 per share to $6. And CMGI (NASDAQ:CMGI) traded from north of $100 all the way down to $1.50.

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 14.6% annually, turning a $10,000 investment into nearly $80,000 today. And when stocks like this temporarily decline, as happened during the recent market swoon, 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 Brown-Forman (NYSE:BF-B), which has paid a regular cash dividend for 61 years. Or boring Stanley Works (NYSE:SWK), which has been rewarding shareholders since 1877. Both have outpaced the S&P 500, returning 14.5% and 13.1%, respectively, per annum 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's service has beaten the market by two percentage points since the service's inception in 2003.

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.

A monster income investment
Finding great dividend payers isn't as simple as merely screening for yields. If it were, everyone would own shares of IndyMac Bancorp (NYSE:IMB) and its 5% yield, even after the company recently cut its dividend in half. But IndyMac is a mortgage lender, and after seeing the business environment toughen up recently, it may need to reduce its dividend again. 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, 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 Invesco (NYSE:IVZ) in February 2005. At the time, the financial giant was trading for $12. Using a discounted cash flow model, our team pegged its fair value closer to $15, later revising that valuation upward. Today, the stock trades for nearly $30, earning investors a nice 150% capital gain to go along with the 3% yield they locked in back in 2005.

There are loads of great dividend-paying stocks, but they're not the market's most popular stocks. 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. No Fool is too cool for disclosure.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.