Needing a victory to maintain a two-point gap to league leaders Barcelona, Real went 2-0 down inside the first half, with goals from Paco Alcacer and Javi Fuego, and a missed penalty from Cristiano Ronaldo capping a 45 minutes to forget for Ancelotti's men.
Pepe and Isco found the back of the net in the second period to ensure that Real got something out of the game, but with Barcelona beating Real Sociedad 2-0, the Catalan outfit now hold a four-point lead with just four matches remaining in the season.
Speaking after the match, Ancelotti admitted that his side simply did not play well enough on the night.
"The result was not good, though the game itself was very good," has been quoted as saying in the Italian press. "We had many chances to score, we fought until the end and deserved to win but it was not enough.
"We paid for little mistakes but the reaction in the second half was very good. My players all struggled and worked hard together. We scored two goals and we missed a penalty. Sometimes this happens.
"La Liga is much more complicated but still there are two games and we must try to win both."
Next on the agenda for Real is a Champions League semi-final second leg clash with Juventus. The Italian outfit hold a 2-1 first-leg advantage, but despite this Ancelotti insists that confidence is high ahead of the match.
"On Wednesday against Juve we will be okay," he asserted. "We are all disappointed with the Valencia result but we are full of confidence. That's how we feel."