shure, why not! i've got my whole webserver on USB and localy on D:\ wich contains all my websites and other stuff..
It's better to install it on a separate partition. I don't think I would go the USB route unless I had to but putting it on a separate drive or partition is generally more secure than putting it on your primary C: drive. If your website gets hacked, this can help prevent access from being gained to the operating system.
@jestep; if they can access files on drive d:/ mostly they also have access to files on other drives..