Dividends to Beat a Crazy Market

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Mr. Market's recent wild mood swings have a lot of investors worried -- and confused. Should you sell your stocks and move your money to something safer like a CD, or should you double-down while prices are low?

There's no one-size-fits-all answer to questions like that. The strategy that's best for you depends on your situation and your tolerance for the kind of volatility we've seen in the markets lately. It's true that bonds, CDs, and money market funds tend to get very popular during times of intense volatility, but they come with disadvantages of their own.

One of the biggest of those disadvantages is that over time, you probably won't make nearly as much money in bonds or CDs as you would have in the stock market. History is clear: Despite the occasional gut-wrenching ups and downs, the stock market is the place to be for the best returns over the long term.

Fortunately, there's a way to invest that can spare you from much of the volatility -- and can even turn it to your advantage. The secret? Steady stocks that pay dividends.

Stocks for a better-behaved portfolio
Some investors will tell you that less volatile stocks tend to be less profitable ones. There's some truth to that -- none of the stocks I'm going to mention are likely to turn out to be "10-baggers," as famed fund manager Peter Lynch used to call stocks whose prices went up tenfold.

But as lots of investors have discovered in recent years, volatile stocks make big swings up and down. It's those down swings that do such big damage to your long-term prospects: As the old Wall Street saying goes, if you gain 50% and then lose 50%, you've lost money -- and that means you'll have less (25% less than you started with, in our example) to invest in the next upswing.

There is a place for higher-risk, higher-growth-potential of stocks in your portfolio. But I'd argue that the cornerstone of your stock portfolio should be made up of slower-movers: Big-name, well-run businesses with a long history of solid dividends that can be reinvested. In times like this, moving assets toward those kinds of stocks can help shield you from the worst of the volatility -- while still giving you some growth.

It's the dividends that power the growth, though some of these stocks have grown pretty nicely on their own. McDonald's (NYS: MCD) price has doubled since the beginning of 2007, with the Dow Jones Industrial Average (INDEX: ^DJI) down about 9% over that same period. Add in dividends, and you're looking at a roughly 130% return in less than five years during a period when many investors suffered immense losses -- on a huge, "boring" stock!

The secret to stocks like McDonald's
McDonald's isn't just your kid's favorite junk-food purveyor, it's a Dividend Aristocrat -- a term coined by Standard & Poor's to denote companies within the S&P 500 index that have raised their dividends every year for at least the last 25 years.

It's not a fail-safe test, but a long history of steadily rising dividends suggests a couple of (very good) things about a company:

  • A tradition of solid management. Companies that can afford to raise dividends every year are those with solid cash flows and managers that have made it a priority to share profits with investors. Those are good things. (But you do need to watch out for companies that can't really afford to raise dividends, but are doing so anyway to try to keep their stock prices up. Fortunately, those aren't too hard to spot.)
  • A share price that's likely to rise as well. You'll find that a stock's dividend yield tends to stay pretty steady over time. With a company that is consistently raising its dividend, that's because the price tends to rise as well -- investors are always attracted to (and willing to pay for) a solid, sustainable dividend.

Solid names to start with
Many of the Dividend Aristocrats are household names, but some of the best ones aren't. For instance, take a look at industrial paint and glassmaker PPG Industries (NYS: PPG) , which has paid a dividend every year since 1899. This five-starMotley Fool CAPS pick's dividend yield, currently right around 3%, has driven a ton of growth for shareholders over the years. Or Air Products & Chemicals (NYS: APD) , a major supplier of medical and industrial gasses that also sports a five-star CAPS rating. It's a cyclical business, but a very high-quality one, with a 29-years-and-counting streak of annual dividend increases.

But that doesn't mean household names aren't worth a look, too. Scotch Tape giant 3M (NYS: MMM) is another five-star CAPS pick, and its 2.9% dividend is a particularly solid one even by Aristocratic standards. And medical giant Johnson & Johnson (NYS: JNJ) may be an exceptionally obvious pick, but it's still a great one, with a 3.6% dividend yield that should pay off in spades over the years -- no matter what the market does. In fact, if you take a long-term view, downward swings in the market can actually be a good thing with these types of stocks, because your reinvested dividends will buy more shares.

One last note: If you're not feeling ready to buy individual stocks, a well-constructed dividend ETF like Vanguard High Yield Dividend (NYS: VYM) can give you some of the same advantages -- a solid yield and lower-volatility exposure to the stock market -- along with some diversification. Don't hesitate to check out that option if it feels right for you. And for more on exchange-traded funds, grab your free copy of The Motley Fool's special report on ETFs. You'll find the names of three ETFs that look to be terrific bets over the long haul.

At the time this article was published Fool contributor John Rosevear holds no position in any company or fund mentioned. The Motley Fool owns shares of Johnson & Johnson. Motley Fool newsletter services have recommended buying shares of Johnson & Johnson, 3M, and McDonald's, as well as creating a diagonal call position in Johnson & Johnson. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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