How I’d use £500 each month to create passive income investments

To earn extra money without working more, Christopher Ruane outlines how he would put £500 each month into UK dividend shares as passive income investments.

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When it comes to passive income investments, sometimes less is more. Rather than cooking up far-fetched moneymaking schemes, I prefer the simple approach of investing some money each month in UK dividend shares.

Why I like UK dividend shares

Dividend shares usually pay holders a small share of a company’s profits. That is called a dividend.

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There is never any guarantee that a company will pay dividends. However, some shares have a strong track record of regular dividend payment. When coupled with promising business prospects, I think that can make them attractive as passive income investments. An example is the consumer products manufacturer Unilever. Last year, it reported a pre-tax profit of €7.9bn. It paid €4.3bn out in quarterly dividends.

Regular saving for passive income investments

There are lots of things I like about the Unilever investment case, from the company’s global exposure to its environmental, social, and corporate governance (ESG) credentials. But what if I’m wrong?

Like anyone else, I can’t tell for sure how a company will perform in future. So I try to reduce my risk by diversifying across a range of companies and business sectors.

Putting aside £500 a month allows me to do that. I could apply the same principle even with just £250 or £50 a month – but it would take longer. That’s because for an investor like me, trading shares isn’t free. Even a small fee on each transaction can eat substantially into my investments if I am only using a very small sum. £500 a month is substantial enough to let me reach critical mass fast. Within my first month, I’d already be able to put £500 into one holding, or £250 into two different companies.

The power of compounding

One of the attractions of UK dividend shares to me is that they allow me to compound my passive income. Let’s say I bought Imperial Brands, currently yielding 8.8%. £1,000 invested would earn me £88 of passive income in the next year, at the current dividend rate. But instead of taking the money, I could simply reinvest the dividends in the company. That would mean I held £1,088 worth of shares eligible for dividends in the second year. Over time, this sort of compounding can produce significant gains. If I compounded £1,000 quarterly at an annualised rate of 8.8%, after 10 years I would have earned roughly £1,388 on top of my £1,000 original investment.

Of course, it might not work like that in practice: the share price could move about and Imperial might cut its dividend. After all, the company faces risks such as increasing regulatory pressure and a fall in smoking rates in many developed markets.

Nonetheless, for my passive income investments, compounding could be a lucrative reward for my patience.

Selecting UK dividend shares as passive income investments

With an extra £500 to invest each month even before counting dividends, how would I decide which shares to buy?

I’d look for shares that I think ought to be able to pay out attractive dividends in the future. Past history can be instructive, but it is no guarantee of future performance. I would look for passive income investments that have a strong position in large markets, and generate substantial free cash flow from which to pay dividends.

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Christopher Ruane owns shares in Imperial Brands and Unilever. The Motley Fool UK has recommended Imperial Brands and Unilever. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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