In a nutshell: yes you do.
Let me explain why.
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SP2, and patches subsequent to SP2, remove vulnerabilities in Windows XP that viruses can exploit to cause problems. Anti-virus and anti-spyware software will protect you if the virus reaches your machine – but they’re not perfect. The vulnerability could be exploited before they detect there’s a problem, and they’ll only detect known malware … if a new virus comes along that takes advantage of something that SP2 fixes, but you didn’t apply SP2, you could be severely out of luck.
New viruses appear every day, and many seem to rely on exactly that – people not keeping up to date. Many infections are the result of people simply not applying all the patches that are available to protect their systems.
As to your concerns about incompatibilities – yes, at the time SP2 was released there were several reported problems with respect to some programs. But by now all the major anti-virus and security packages have been upgraded to work properly with SP2.
So the bottom line is:
- Yes, you should make sure your security software is also up-to-date and SP2 ready.
- Yes, you should install SP2.
As I said, this is all a part of a larger strategy I’ve covered in an earlier article: How do I keep my computer safe on the internet?.