Via Jeff Atwood (aka Coding Horror):

If you use virtual machines at all, you should have the single most important virtual machine performance tip committed to heart by now: always run your virtual machines from a separate physical hard drive:

[the] biggest performance win is to put the virtual hard disks on separate disk spindles from the operating system. The biggest performance hit in virtual machines is disk I/O. Making the VM fight with your OS and swap disk makes this issue much, much worse. Additionally, today's USB 2.0 and firewire external hard drives run on a fast interface bus, have large buffers and spin at 7,200 rpm, as opposed to 4,200 rpm for most laptop hard drives.

And later on mentions the following:

That's one reason why all the desktop machines I build now have two hard drives:

1. A faster, smaller drive for the operating system and essential applications. You can't beat the 10,000 rpm Western Digital Raptor series for this role.
2. A larger data drive for virtual machines and everything else.

I normally don't chime in with "me too" posts, but I'll break that tradition for this one.  Jeff goes into further detail (along with spiffy visuals) about exactly why this is beneficial...in short secondary drives don't have to contend with OS chatter on the system drive.  I've been using the exact setup he describes for almost 2 years now (10,000 RPM internal drive for system and core applications like VS, Office, games, etc and an external for data and virtual machines), even though my system drive is a scant 74 gigs it still has over 20 gigs free space.  VM performance on my external drive is much better than when I first had them located on my system drive; external bus links are getting fast enough that in the near future I can start installing games on my external drive as well (which is good seeing that the next generation of games are coming in at 10 gigs or more of necessary drive space).  Great post Jeff.