You won't lose any files.
The idea is that your hard drive, when it saves files, doesn't always save the same thing in one place. So, in order to read the whole file, it has to skip around a little bit. If you defragment your disk, it combines the saved parts of movable files so that they are together, and more easily accessible. This allows your computer to run faster.
It takes a while, so run it at night when you're sleeping, or when you're out for a while.
It won't destroy your files.
With Windows XP, you should find it under: start menu > all programs > accessories > system tools > disk defragmenter.