John Maynard Keynes once quipped, "Markets can remain irrational longer than an investor can remain solvent."

The noted market historian was right. Capital preservation is key with instruments such as Treasuries or government bond funds, but history shows that despite periods of losses, over long periods of time stocks have always returned more than bonds.

Since 1802, stocks on average have risen 7 percent versus 3 percent for long-term Treasury bonds.

Still, investors should think carefully about their reasons for taking on the risk of owning equities. In particular, in the event of a sustained bear market for stocks, investors should question their expectations for capital gain.

Microsoft, for example, in conjunction with many technology companies, never paid a dividend until the software giant announced in January 2003 that due to a strong rise in second-quarter profits it would return some its enormous cash to investors through its first-ever cash dividend. The announcement came just a few months before the new tax plan to reduce the rate on dividends. Until this year, Microsoft was the only company in the Dow average not to issue a dividend.

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If markets trend sideways, companies unable — or unwilling — to generate and distribute cash will be pointless investments.

Dividend-paying stocks, therefore, are often lifeboats in a storm. Companies that pay dividends show a sign not only of financial strength but also of management discipline and management commitment to shareholders.

Additionally, recent studies show that dividend payers generally outperform in both bull and bear markets. In one case, analysts studied the median quarterly returns of two groups of stocks, those that paid dividends and those that didn't or paid only small ones.

They looked at how the stocks performed at various times during the '90s bull and this decade's bear markets. Not surprisingly, the first group shined during the bear market, and when analysts tracked the stocks from 1993 to 1998 — the pre-bubble bull period — they found that the dividend stocks also did better. Their only weak period: The 1998-2000 boom in dot-coms.

According to Standard & Poor's, in 2004, dividend-payers returned 18.35% compared to 13.65% from non-dividend payers. S&P reports that this has been the case for 13 of the past 18 years.

How Dividend Stocks Work

So what are dividends and how do they work? They are simply the cash payments companies make to share their profits. The dividends are paid to individual stockholders and stock mutual funds that are stockholders.

To pay taxes on qualified dividends at the long-term capital-gains rate, an investor has to hold the stock for more than 60 days out of a 120-day period, which begins 60 days before the stock's ex-dividend date.

The ex-dividend date is typically about three weeks before a dividend is paid to investors of record.

Stock mutual funds that receive dividends from companies are required to pass them along to fund investors after deducting management fees and other charges. The holding-period requirements that apply to individual stockholders also pertain to mutual funds and fund investors receiving dividends.

A company's board of directors decides whether to pay a dividend and then sets the amount.

The timeframe varies as far as when companies pay dividends directly to investors. Stock mutual funds that receive dividends pass them along to investors at a regularly scheduled time after deducting management fees and other charges. Generally, a mutual fund issues investors a dividend quarterly, semiannually or annually.

Four Reasons to Buy Dividend Stocks

Reason #1: Dividends add substantially to your stock returns. The huge returns (and low dividends) of the late 1990s and early 2000s were an aberration. Over the long term, dividends have accounted for a full one-third of total returns from the stock market, based on the S&P 500.

In ten years, a 7% dividend will more than double your money.

Moreover, dividends are based on current stock prices - not what you originally paid for the stock. So if your shares double in value and you get a 7% dividend, you are effectively receiving a 14% return year after year.

Reason #2: You get much higher returns than any bank can offer. Even with recent interest-rate increases, most banks are still paying a paltry 3 or 4% in interest on savings accounts and CDs. That's far less than you can get from the dividends of many stocks.

And in order to get even these small bank returns, you have to tie up your money for 12 to 24 months - or longer. If you want your funds back sooner, you have to pay substantial penalties for early withdrawal.

In contrast, dividend stocks require no long-term commitment and you can sell your shares at any time.

Reason #3: Dividends are tax-advantaged investments. Thanks to recent tax legislation, you now pay a maximum of 15% federal tax on dividends, compared to as much as 40% on bank interest and other income. That makes dividends even more lucrative.

Reason #4: You can get both high dividends and high appreciation. There are many safe stocks that now pay you 3 to 10% in annual dividends year after year - on top of more than 30 to 70% annual appreciation in share value.

All of these benefits make dividend stocks well worth considering. What to Look for When Searching for Dividend Stocks

For investors looking to boost their income, stocks with price-stabilizing dividends are as attractive as ever. Not only can dividends add a nice income boost on top of share-price returns — they also can offer shareholders extra traction during a sell-off. When markets get choppy, the added lure of income can prevent steep losses in dividend-paying stocks.

To understand, a dividend yield is a company's annual dividend rate divided by its stock's latest closing price. For example, the yield for a $20 stock that paid $1 in dividends last year is 5 percent, the same as for a $40 stock that paid $2. There are two ways a stock's yield can grow:

1. The company decides to increase its dividend payments to shareholders. 2. The stock price falls, meaning investors can buy into that dividend for less money.

Experts often use the five-year Treasury note yield as a comparison for searching for dividends but say investors should not limit their choices by omitting stocks that have potential share-price appreciation.

A company's forward price/earnings ratio should fall below the Standard & Poor's 500 average, since stocks with low valuations generally have more potential to climb over time.

Investors should make sure the company has plenty of cash on the books and that the dividend is coming from excess cash flow. After shareholders are paid, there should still be room for capital spending and things like acquisitions, research and development, and share buybacks.

Investors can tell how much cash a company is using to cover its dividends by looking at the payout ratio, or the percentage of earnings paid out in dividends over time.

Yields on dividend stocks also should not be astronomical. When stocks pay sky-high dividends, it could be a red flag and the payout could be unsustainable, although there are exceptions.

Mutual funds are also an excellent way to pick up dividends. They give the added benefit of diversification by owning stocks in different industries.

There are some excellent funds that invest in dividend-paying stocks. Consider: Fidelity Equity-Income, Fidelity Equity-Income II, Vanguard Equity Income Fund Investor Shares, T. Rowe Price Equity Income, Parnassus Equity Income, Gabelli Equity-Income, and American Century Equity Income Investors.

For those investing in individual stocks, a word of advice: Companies often can and do cut their dividends to save cash. To keep out the ones most likely to pull back their payments, experts say payout ratios should fall below 75 percent.

That means a company is paying less than three-quarters of its profits out as dividends. Utilizing a lower payout ratio is good, since companies can afford to keep paying those dividends.

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