Beat the Market With Less Risk

This article has been updated since its initial publication on Dec. 1, 2003.

There's no question that dividend-paying stocks have been less volatile than their stingier brethren over the years -- meaning there's a greater chance that your money will be there when you need it. In fact, they tend to contribute little more than 10% of the volatility of the market as a whole while still managing to beat the market's total return. What's this? You mean you can get better returns with lower risk just by purchasing dividend-paying stocks? You betcha.

The standard line in relation to investment risk is that those who take on more risk are destined to receive more reward. While there's definitely a large element of truth in this, it's true only to an extent. But as this mantra has been drilled into our heads over the years, we as investors now have a tendency to dramatically overestimate the amount of risk that must be taken in order to achieve respectable returns.

Indeed, at a particular point, each incremental unit of risk that you take actually produces a smaller amount of return. This is largely because, as you start to swim deeper and deeper into the risk pool, you have fewer winners and more failures inhibiting your overall success rate.

Unfortunately, there's no magic number that tells us when the additional return is no longer worth the risk. So, ultimately, we have to learn where that cutoff lies for us as individuals in order to maximize returns for the amount of risk that we're willing to take.

However, in the investing world it's often possible to dramatically increase our returns while reducing our risk by seeking companies that possess certain characteristics. And, to that end, it turns out that whether or not a company pays a dividend is a rather important characteristic.

The real deal
Do you need proof in order to believe that you can actually receive greater returns while taking on less risk just by investing in dividend-paying stocks? Well, you should need proof. After all, how many times have I told you never to believe anything from the financial media without an awfully compelling explanation attached to it?

Fortunately for us, I happen to have several right here. First, consider the numbers. Standard & Poor's has been kind enough to share some rather important dividend data over the years, such as the fact that dividends have accounted for 42% of the S&P 500's total return since 1926 -- that's right, nearly half of that 10.2% market return that everyone talks about really came from the little ol' dividend. In addition, over the past 25 years, S&P 500 dividend payers have beaten nonpayers by nearly 3% per year. That may not sound that significant, but statistically this is a monster outperformance.

But I said I had several explanations, so I won't stop there. BusinessWeek has pointed out that the return of the Nasdaq stock market, known for its healthy dose of aggressive technology stocks, actually underperformed the S&P Utility Stock Index from 1971 through late 2001 -- 11.2% vs. 12%, including dividends.

Again, the actual difference in return is modest, but the real importance here lies in the fact that the utility investors took on substantially less risk to achieve their return, making the difference on a risk-adjusted basis much more meaningful.

Indeed, the utility index beat the Nasdaq while incurring about half its volatility. The bottom line: During this period, Nasdaq investors were not adequately compensated for the amount of risk they took on when compared with utility investors, so don't take unnecessary risks in your portfolio. In the end, one could have achieved a higher total return, experienced far less price fluctuation, and maintained a substantially higher level of income by owning the boring utility index.

The dividend answer
I'm not saying that every stock in your portfolio has to be a dividend stock -- far from it. However, investors must always be conscious of the level of risk that they're taking to achieve their reward, and historically speaking, dividend-paying investments have offered the most compelling risk-reward trade-off available. Opportunities to achieve above-average returns while taking below-average risk abound in this investment category.

For instance, the best-performing investment selection for Motley Fool Income Investor is currently RPM International (NYSE:RPM). This company has returned nearly 36% over the past year for our subscribers, pounding the S&P's 13%. Despite its increase, the firm still boasts a yield of 3.2%. The real story here, however, is that the company has produced its market-beating return while being only half as volatile as the overall market. So, again, on a risk-adjusted basis the return is even more favorable.

Numerous other Income Investor selections are in the same category, but for some even more compelling, longer-term statistics, we need look no further than the stocks I selected on Fool.com back in March 2003 for the Six-Pack Portfolio. The Six-Pack, with investments such as Altria (NYSE:MO), BellSouth (NYSE:BLS), and ConAgra Foods (NYSE:CAG), has produced a total return of 56.35%, comfortably beating the 42% gain in the S&P 500 (both include dividends).

Indeed, before gracing the pages of the newsletter my recommendation of RPM first appeared in this portfolio, where it has since generated an even more favorable 116% total return. The second best performer in the group is Stanley Works (NYSE:SWK), which weighed in with a 95% return. The portfolio contains just one loser, Newell Rubbermaid (NYSE:NWL), which has slumped by 18.4%. You'll find the full results in the table below.

Six-Pack Picks

Another important aspect of the income-investing strategy is that dividend payers tend to fall only half as much as nonpayers in down markets, as the yield helps to support the shares. A great many investors have wished that they had a few such companies in their portfolios when the bears came calling. If you and your stomach endured the wild rides of a Cisco Systems (NASDAQ:CSCO) or an Amazon.com (NASDAQ:AMZN) in the late 1990s, think about how much money you'll save on Maalox consumption once you're in solid, dividend-paying stocks.

The Foolish bottom line
Identifying one's risk tolerance is a difficult process. Can I truly stomach the volatility of my investments? Am I OK with the idea that I could actually lose money? Does Mathew have any hair under that jester's cap? But the good news is that there's an entire investment approach that can keep you in the shallow end of the risk pool without drowning you in underperformance. Join the income investors, and fall asleep when your head hits the pillow.

As a final note I would offer this: Certainly, it's in my best interest as the author of a dividend newsletter to preach the benefits of a dividend-oriented investment strategy. But let's take the obvious a step further. I don't write about dividends because of a newsletter; I write a newsletter because I believe in dividends. I was writing about this approach long before I began writing Motley Fool Income Investor, as the results speak for themselves.

I've employed these methods with great success in my own portfolio, and I've since produced excellent returns for my subscribers -- far greater than those they would have achieved by investing in the S&P 500. Consider allowing me to do the same for you. It won't cost you a dime to kick the tires and see exactly what our subscribers see for a full 30 days. You have my personal assurance of quality and the money-back guarantee of the Motley Fool. That's our commitment to you.

Fool on!

Mathew Emmert doesn't just play one on TV -- he's a real dividend investor. You probably never would have guessed, but he's also the author of the stock-picking newsletter, Motley Fool Income Investor . He owns shares of Altria and RPM International. The Fool has an ironclad disclosure policy .