Managing Notional vs Real losses in mutual fund investing
- Abraham Cherian
- Apr 19
- 10 min read
First principles: what is a loss, really?
From a technical (tax) point of view:
A capital gain or loss exists only when you sell or redeem units. If the fund value is up or down but you are still holding, there is no capital gain or loss for tax purposes yet.
When you sell for less than your purchase NAV, it becomes a realised (real) loss. When you sell for more, it’s a realised gain.
As long as you haven’t sold, the ups and downs are unrealised / notional gains or losses – they are just changes in valuation on paper.
Think of a flat you bought for ₹50 lakh. If the “market price” today is ₹40 lakh, you have a notional loss of ₹10 lakh, but you haven’t actually lost that money until you sell at ₹40 lakh. The day you sell at ₹40 lakh, the ₹10 lakh becomes a real loss.
Exactly the same logic applies to mutual fund units.
How notional losses show up in mutual funds
In mutual funds, notional losses typically appear in three situations:
Market corrections: A broad fall in equity markets drags down NAVs across almost all equity schemes. Your portfolio values fall temporarily, but you haven’t sold anything yet. This is a classic notional (paper) loss.
Sideways or volatile markets: NAVs move up and down within a range. One month your SIP shows a loss, six months later the same SIP shows a profit. Till you redeem, these are all notional movements.
Fund‑specific underperformance: Your fund lags its benchmark and peers for an extended period. The portfolio value is lower than what it could have been in a better fund. The underperformance gap is an economic loss, but from a tax perspective it becomes real only when you actually exit the laggard fund.
Key point: Notional loss is about current portfolio value vs your purchase cost. Real loss is about sale price vs purchase cost on the day you actually exit.
When a notional loss should be ignored
There are situations where reacting to a notional loss is harmful:
A sharp but broad‑based market fall, while your funds are fundamentally sound and aligned to your goals.
Your time horizon is still long (7–10+ years), and the fall is well within the range of normal equity volatility.
Your asset allocation (equity vs debt vs cash) is appropriate for your risk profile and goals.
In such cases, redeeming because the value is down converts a temporary notional loss into a permanent real loss, and you also lose the benefit when markets recover later.
Here, the right action is usually: Keep SIPs running, review asset allocation, and do nothing emotional.
When a notional loss should not be ignored
There are other situations where doing nothing is riskier:
The scheme has consistently underperformed its category and benchmark over 3–5 years, even after market cycles.
The investment no longer fits your strategy (for example, sector/thematic fund taken for a short‑term idea that is now irrelevant).
Fund house strategy or risk has changed, and the scheme no longer matches your comfort.
Here, the loss is already there in economic terms – your money is sitting in an inefficient vehicle. Holding on just to “avoid booking a loss” often delays the inevitable and costs you future returns.
In these cases, exiting an old scheme and reallocating to a stronger one is usually a sound portfolio decision, even if it means “showing” a loss today.
The emotional trap: “If I switch, I’ll book a real loss”
This is where many investors get stuck:
“My old equity scheme is 15% down. If I sell and move to a better scheme, I’ll book a real loss. Let me wait till I at least come back to cost, then I’ll switch.”
The problem with this thinking:
The 15% is already gone – the market and the fund’s underperformance have already happened.
Whether you stay in the same scheme or switch to another, your starting capital today is the same reduced amount.
By staying in a weak scheme, you may lose future opportunities in stronger funds.
Economically, switching from a poor equity scheme to a better equity scheme does not create a new loss. You have one existing loss (already embedded in your current NAV); you are merely deciding where that remaining capital should work for you going forward.
From an advisor’s lens: The decision to switch is about future expected returns and risk, not about avoiding the emotional pain of “booking” the past loss.
Is switching from an underperforming equity fund a “real” loss or “notional” loss?
Let’s separate this carefully, because language can confuse investors:
Tax and accounting lens
For tax purposes:
When you redeem units of the old equity fund at a lower NAV than your purchase NAV, you have a realised capital loss.
This realised loss is recorded and can be used for tax loss harvesting, subject to Indian capital gains rules (more on that shortly).
So, for income tax, the loss is “real”.
Economic / portfolio lens
From an economic perspective:
You already suffered the loss while the fund was falling – your capital is already reduced.
Staying invested in the same bad fund does not reverse that loss; it only postpones the date on which you acknowledge it.
When you exit the weak fund and enter a better fund (keeping overall equity allocation intact), you are not losing more money because of the switch. You are simply re‑deploying the remaining capital into a more efficient vehicle.
In that sense, switching schemes doesn’t create a new loss. You are only recognising an existing notional loss and using it to potentially improve future outcomes and possibly get tax benefits.
So you can think of it this way:
Real loss in tax books.
No additional loss in overall net worth – you are just restructuring the portfolio for better future performance.
A simple example: switching from a legacy fund
Imagine:
You invested ₹10 lakh in Fund A (an old equity fund).
After a few years, due to underperformance, your value is now ₹8 lakh.
A stronger Fund B in the same category has a much better long‑term track record and risk control.
You are considering:
Holding Fund A till it “comes back to ₹10 lakh”.
Exiting Fund A at ₹8 lakh and investing ₹8 lakh into Fund B.
Key points:
In Option 1, you are betting that an underperforming fund will suddenly become efficient enough to recover your capital.
In Option 2, you accept the already‑happened loss of ₹2 lakh, book it, and put ₹8 lakh into a better vehicle that has a higher probability of compounding well over the next 10–15 years.
Economically, your wealth is ₹8 lakh in either case today. The smart question is:
“Which fund is more likely to turn ₹8 lakh into a much larger number by my goal date?”
That is why, treat the “loss” on a legacy underperformer as something that is already in the past and focus on future asset allocation and fund quality, not on ego or anchoring to your original purchase price.
Tax basics: when does a loss matter?
For mutual funds in India, capital gains/losses are recognised only on sale/redemption of units.
For equity and equity‑oriented mutual funds (as per current rules):
Short‑term capital gains (STCG):
Holding period: up to 12 months.
Taxed at a flat rate (currently 20%).
Long‑term capital gains (LTCG):
Holding period: more than 12 months.
Gains above ₹1.25 lakh in a financial year are taxed at 12.5%.
For capital losses:
Losses become powerful tools only after they are realised (sold). Notional losses have no tax value.
What is tax loss harvesting in mutual funds?
Tax loss harvesting is a legal strategy where you deliberately sell investments at a loss to offset taxable capital gains, thereby reducing your overall tax outgo.
The basic steps are:
Identify holdings in loss: Equity or debt mutual fund units where the current value is below cost.
Redeem those units to realise the loss. The notional loss becomes a realised capital loss for tax purposes.
Use this loss to offset gains from other funds or stocks where you have realised capital gains. This reduces taxable gains and hence the tax payable.
Reinvest the proceeds into either the same fund (after a suitable gap, if needed for compliance and practical reasons) or a similar fund to maintain your asset allocation.
In short, you’re converting a red number in your portfolio into a tax asset that reduces your tax bill.
Numerical illustration: converting notional loss to tax savings
Assume the following (simplified):
Fund X:
Invested: ₹5,00,000
Current value: ₹6,00,000
Potential long‑term capital gain if you sell now: ₹1,00,000
Fund Y (legacy underperformer):
Invested: ₹5,00,000
Current value: ₹4,00,000
Notional loss: ₹1,00,000
Without any action:
If you redeem only Fund X, you realise a gain of ₹1,00,000 and pay LTCG tax (subject to exemption limits), say at 12.5% beyond the threshold.
With tax loss harvesting:
You redeem Fund Y, realising a capital loss of ₹1,00,000.
You redeem Fund X, realising a capital gain of ₹1,00,000.
For tax purposes, your net capital gain is approximately zero (₹1,00,000 gain – ₹1,00,000 loss).
Your tax outgo on these transactions can drop sharply, sometimes to almost nothing in that year, depending on thresholds and other gains.
You then reinvest the proceeds from both funds into:
A better replacement for Fund Y, and
Either back into Fund X (if still suitable) or to another appropriate fund.
You started with notional loss in Fund Y. By acting smartly, you converted it into:
A realised loss that cancels out a gain elsewhere, leading to tax savings.
A cleaner, better‑structured portfolio going forward.
Always check actual tax rules and consult your tax advisor, because rates/thresholds can change over time.
Using tax loss harvesting when restructuring legacy equity schemes
Now let’s combine both ideas:
You have legacy underperforming equity schemes showing losses.
You also have other equity funds or stocks with significant gains in the same or coming financial year.
A practical approach:
Review performance and suitability
Identify schemes that are structurally weak or consistently underperforming.
Decide to exit laggards for strategic reasons
This is a portfolio quality decision, not just a tax decision.
Time the exit smartly
If possible, align the exit with years where you also have significant capital gains to offset.
Realise losses and re‑deploy capital
Redeem the legacy funds, realise the losses, and shift the money into better, well‑researched funds.
Document and track losses carried forward
If losses exceed gains in that year, carry forward eligible losses for future set‑offs.
Result:
You are not “creating” a new loss – you are recognising an existing notional loss that was anyway hurting your long‑term returns.
You are using that recognised loss as a tax shield, reducing your tax on gains from other investments.
Your portfolio becomes simpler, more focused, and better positioned for future compounding.
Different market conditions and how to respond
Here’s how to think about notional vs real losses in different environments:
Deep market correction (like 2020‑type falls)
Most diversified equity schemes fall together.
If the fund quality is good, this is usually a notional loss situation where you should avoid panic selling and keep SIPs running.
Use the correction to rebalance (shift some debt to equity if your allocation allows), not to abandon equity altogether.
Prolonged sideways / range‑bound market
You may see periods of small notional losses in newer SIPs.
Focus on units accumulated at lower NAVs, not on short‑term valuation.
Reserve “booking losses” mainly for clear restructuring or tax‑harvesting reasons, not mild noise.
Structural underperformance in a fund or category
Example: A sector or thematic fund that had its day in the sun and then lagged for years.
Here, accepting and booking the loss to move to diversified, stronger funds is often wise, especially when combined with tax loss harvesting.
Mania / overheated markets
Your portfolio shows strong notional gains.
Strategic partial profit‑booking plus simultaneous booking of losses in weaker holdings can help you lock in gains and reduce tax in a disciplined way.
Practical rules of thumb for investors
To make this actionable, you can use a few simple rules:
Rule 1: Don’t react to every red number. Corrections in otherwise sound, diversified funds with long time horizons are usually just notional losses to be ignored, not reasons to exit.
Rule 2: Differentiate between “market risk” and “scheme risk”.
Market risk: Almost all equity funds are down together – mostly temporary.
Scheme risk: Your fund is a repeated laggard vs benchmark and peers – here, restructuring is justified.
Rule 3: When you switch from a bad equity fund to a better one, focus on future returns. Don’t obsess over “I am booking a loss”; focus on “Is my remaining capital in the best possible place now?”
Rule 4: Use losses deliberately at year‑end. Once a year (often closer to financial year‑end), review for tax loss harvesting opportunities to offset gains and tidy up legacy holdings.
Rule 5: Always see tax as secondary to strategy. Tax optimisation should support – not drive – your core asset allocation and goal planning.
What you can do next
The big idea is simple:
Notional losses are part of equity investing; they become dangerous only when you panic.
Real losses are inevitable at times, but they can be used intelligently – to exit weak schemes, improve portfolio quality, and reduce tax through tax loss harvesting.
What you can do next:
List your equity and hybrid mutual funds – note investment amount vs current value.
Classify losses – temporary market‑wide falls vs long‑term scheme underperformance.
For temporary market‑wide notional losses, stay disciplined, continue SIPs, and review asset allocation.
For legacy underperformers, seriously evaluate switching to stronger schemes, using the realised loss as a tax‑efficient way to restructure.
If needed, sit with a SEBI‑registered investment advisor to build a written plan for restructuring and tax loss harvesting aligned to your goals and risk profile.
Used correctly, “losses” are not just painful numbers on your screen – they are also raw material for better portfolios and lower taxes.
Disclaimer: This content is for informational purposes only and does not constitute financial or tax advice. Investments in the securities market are subject to market risks. Read all the related documents carefully before investing.
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