After posting stellar returns in 2013, the broad U.S. equity markets are off to a good start in 2014, with the S&P 500 up just over 7% through early July. While it’s easy to overlook the value of dividends during bull markets like this one, they remain a key component of equity returns from a longer-term perspective.

From 1927 through year-end 2012, the dividend component of total return amounted to 42% for large-cap stocks, 36% for mid-caps and 31% for small-caps, according to a March 2014 report from Al Frank Asset Management, “Value of Dividends,” which cites historical data from Morningstar’s Ibbotson Associates.

Performance Characteristics

A recent study by Jeremy Schwartz, director of research with ETF-sponsor WisdomTree in New York, illustrates the power of dividends. The research updated work done by Wharton professor Jeremy Siegel in his book, “Future for Investors.”

Siegel divided the S&P 500 dividend-paying stocks into five groups, ranked from highest to lowest dividend yield. From Dec. 31, 1957, through Dec. 31, 2013, the highest-yielding stocks produced both the highest returns and the lowest beta. The two highest-yielding groups significantly outperformed the S&P 500 for both return and risk.

Mike Boyle, executive vice president and head of asset management with Advisors Asset Management in Lisle, Ill., has conducted similar research into dividends and beta and concurs that dividend payers have lower betas than the overall market. Over the last three years, the average market beta has been 1.1. (That’s not an error, he explains—it’s the result of the mathematical formula for beta.) For dividend stocks paying above 2%, beta for the period was 1.0, and for yields over 4%, beta fell to 0.6.

As dividends go above 4%, about twice the market level, betas go down significantly—because investors are not “renting” the stocks, he maintains: “Those are people that have pretty strong positions in perhaps some of the tobaccos, some of the utilities and some of the consumer telecoms.”

Inflation Protection

Dividend growth has traditionally tracked earnings growth, which has averaged about 6% a year, according to John Crawford Jr., director of equity investments with Crawford Investment Counsel in Atlanta. That value is higher than most measures of inflation over longer periods of time, so dividend-paying stocks should provide purchasing power protection.

Plus, this means dividend-paying investments can offer investors better inflation protection than bonds, generally speaking. “You think about a bond, which is fixed income. That payment is set so it is going to get eroded over time by inflation; whereas, dividends can grow at or in excess of inflation,” he explains.

Treasury Inflation-Protected Securities (TIPS) are a popular choice for inflation protection, but they have their shortcomings, says Schwartz. A 10-year TIPS bond had a yield of about 24 basis points in late June, which means a buyer receives only 24 basis points of real (after-inflation) yield.

In contrast, a portfolio of large-cap dividend paying U.S. stocks can generate about 2.7% yield. Factor in the potential for dividend growth, he says, and dividend stocks can act like a “super-TIPS.”

“When you look at the long-term inflation vs. dividend growth, inflation has only been about 4% a year going back to 1957, but dividend growth has been over 5(%),” the expert stresses.

Jim Morrow, portfolio manager of the Fidelity Advisor Equity Income Fund in Boston, points out that the current levels of dividends vs. bond yields have moved away from their normal trading relationship. Historically, he says, investors had to pay a 200 to 400 basis points penalty to move out of bonds into stocks.

In other words, investors gave up anywhere from 200 to 400 basis points of yield when they switched from bonds to stocks, given the usual yield spread between the 10-year bond and the stock market.

That’s not the case currently—investors can essentially move over at parity, and that is a very unusual environment. You have to go back to the 1950s, 60 years ago, to find anything even close, he says.

This means the penalty to move from bonds to stocks is only one of volatility; it’s not one of actual income loss, and investors can participate in the potential benefits that accrue to shareholders.

“I think it’s an interesting point in time for people to do asset allocation, because from an income basis, you can build a really nice portfolio with a yield over 3%,” Morrow adds.

Rising Dividend Payouts

About 85% of the S&P 500 stocks now pay dividends, Boyle observes, a value that’s approaching a 20-year high. Using full-year comparisons, his research shows that the S&P 500′s annual dividend has increased about 12% year over year.

“The long-term average is 6.17%,” he says. “So dividends right now, year over year, are growing (at) about twice the 40-year average.”

The outlook for dividend increases remains positive, and statistics from S&P Dow Jones Indices support the case that dividends will continue to move higher.

For the first half of this year, 1,774 issues increased their payments, up 15.6% from the 1,535 issues that increased their payments during the first half of 2013; only 159 companies cut or suspended their dividends in the first half of 2014, down from 204 in 2013.

‘A Record Year’

Given the dividend payments made in the first half of the year and the declared dividend rate for the second half, S&P Dow Jones Indices reports that 2014 could be a record year for dividend payments.

Firms like W. P. Carey, a net-lease REIT based in New York, are doing all they can to produce such robust dividends.

“Combining our established capabilities with strategies implemented over the last year, we look forward to continuing to increase adjusted funds from operations (AFFO) and dividends, growing total assets owned and under management, and creating long-term value for our stockholders as we source and secure opportunities we believe to be uniquely available to us,” said President and CEO Trevor Bond.

Balancing Risk

Basic portfolio-building principles still apply to dividend stocks, of course. Fran Kinniry, a principal in Vanguard’s Investment Strategy Group in Valley Forge, Pa., cautions dividend-seekers against several inadvertent errors.

The first is reduced portfolio diversification due to excess concentration in a small number of high dividend stocks. This can happen with a portfolio of mutual funds as well as individual holdings, if the investor overweights the same stocks. Style concentration is another potential risk, because many of the best-known dividend stocks are large-cap value companies.

Fortunately, it’s possible to create dividend-oriented equity allocations that are well diversified. Several Nasdaq OMX Dividend Achievers Indexes, for example, cover Canadian and other international companies, such as those in the United Kingdom.

Investors can also consider ETFs and mutual funds that offer broad or focused exposure to different market cap segments and global segments. It’s estimated that companies outside the U.S. pay about 75% of the world’s dividends, which gives investors numerous opportunities.