"Smart object" is a kind of "child" file embedded in its "parent" document.
in the Layers palette you can recognize a smart object by special symbol on its thumbnail.
How to create a smart object in PSE:
- In the Layers panel, select a source layer. To make a smart object from several layers, combine those in a layer group.
On the screenshot, the source layers are inside the "Group 1".
- In the Effects panel, double-click the "Convert to Smart Object" thumbnail. Done!
Why use smart objects? Well, the first reason is, that they can be transformed non-destructively (more about).
And even more important reason is smart filters. Imagine, that you can apply several filters to a text and then edit its contents without starting all over again.