One of my worries about doing this was the potential privacy and security issue of losing the key. My key, filled with masses of personal information could be potentially misused in the hands of evil.
So I went looking for encryption. The best I found was TrueCrypt and I highly recommend it.
What I wanted was:
TrueCrypt does this an more.
My encrypted files are presented as a another drive letter that is either mounted automatically on inserting your USB key (with Windows Vista or XP SP2 via an autorun.inf file) or by running the application and clicking "Mount". Both options require you to enter your password once and once only. If you get the password wrong the drive doesn't mount and your encrypted files are inaccessible.
Once mounted I have two drive letters for my key, the encrypted files and the unencrypted files. I can label the drives with volume names to reduce confusion, they act just like any other drive.
The only irritation is that you must open the app (which sits in taskbar next to the portable drive icon while running) and click "Dismount" before removing the key else you may suffer data corruption. As if the usual horrific Windows "Unplug or Eject Hardware" wasn't bad enough now I have to do it twice. However, it's only a minor irritation that I entirely blame Windows for.
Rarely do I find a piece of software that does exactly what I wanted but TrueCrypt managed this. And to top it off it's free, open source and works on multiple platforms.