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How I’d use £500 to target passive income from UK dividend shares

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Passive income can provide some useful extra cash. One of my favourite passive income ideas is investing in UK dividend shares. But there’s a dilemma sometimes — if I had lots of money to invest in shares, I might not be hunting for passive income in the first place.

Fortunately, I think it is possible to aim for passive income even with a relatively modest sum of capital to invest. If I had £500 to put into dividend shares and wanted to start earning passive income, here is how I would do it.

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Risk and reward

While £500 is enough to let me invest in the stock market, it doesn’t leave much margin for error. There is always some risk in the stock market whatever one does, but I do think it’s possible and indeed wise to try to reduce that risk.

I would do that in this case by spreading my £500 over more than one share and business sector. I’m mindful of the impact of trading charges here, so realistically I think I would aim to invest £250 in each of two companies. That is not a huge amount of diversification, but at least it is some.

I would also look for a margin of safety more than massive potential reward. So I’d opt to invest in companies with substantial free cash flows which could help pay dividends, a durable-seeming business model, and a track record of paying out dividends. That doesn’t guarantee future dividends, but it shows the management does consider the interests of shareholders who appreciate dividends.

Passive income pick 1: National Grid

My first choice would be National Grid (LSE: NG). With a dividend yield of 5%, my £250 ought to earn me around £12.50 a year in passive income. National Grid typically has modest annual increases in its dividend. So over time, I would hope my passive income from holding it could increase. Yesterday, for example, it announced that its interim dividend would increase by 1%.

I think the company’s business owning and operating power distribution networks meets my investment criteria above. Demand is high and likely to remain that way. Competition is limited, which helps the company generate substantial free cash flows. Those could be dented by higher capital expenditure costs, due for example to changing patterns of work. But I’d accept that risk in investing in National Grid.

Passive income pick 2: Legal & General

My second pick would be financial services provider Legal & General (LSE: LGEN).

Many people are familiar with the firm’s iconic colourful umbrella logo, but they may be less familiar with the company’s bright financial performance. The umbrella and an established brand overall help Legal & General maintain a strong position in the UK market. Its entrenched customer base is sizeable. A lot of financial services customers roll over their use of a firm’s services without much consideration. I also think the company’s vision of “inclusive capitalism” could help it attract newer customers and build revenues.

The company yields 6.2% and has set out plans to increase its dividend payout in coming years. That isn’t guaranteed: risks here include profit margins falling due to higher claims costs. But with its strong brand, high market penetration, and well-oiled business model, I’d happily hold Legal & General in the hope of growing my passive income streams.

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Christopher Ruane has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. 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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