What ain't there and ought to be.

[Lalwendë]

This is interesting - why do Hobbits live in Hobbit holes and what does it mean? Firstly, I have to point out that not all Hobbits live in smials, and surely the practice would eventually become more obsolete as the population of The Shire grew and it became harder to find suitable hole delving 'real estate'?

I like Child's idea of the smial being developed from Tolkien's experiences in the trenches, but I'd like to turn it around a little and look at a hole in the ground as being a place of safety. During trench warfare, the 'hole in the ground' would be the only relatively safe place to be. It was above ground that the real dangers lurked. And smials are not deep holes, they are not like the tunnels of the Dwarves and Orcs, they have windows and while snug and safe, they are also close to the surface. The dangerous tunnels might be like those seen in Birdsong, dug deep beneath the trenches for the purposes of undermining the enemy front lines. So, perhaps Tolkien saw the smial as emblematic of relative safety.

Many of the faerie folk live inside hills

There is definitely something interesting in this, and rather than Hobbits being animal, I think they are far more faerie. They are slightly, but not completely, hidden in their smials. They are in effect camouflaged; like inhabitants of faerie, we can see them if we try just hard enough to look beyond what we expect to see (i.e. just a hill), and they are always there. If we don't allow oursleves to 'see' then we will not notice them, rather like Sauron fails to notice the existence of Hobbits, as he is unable to make himself open to the possibility. In some ways, Hobbits are more like the inhabitants of Faerie than the Elves are. They are more linked with our folklore, and more like us, like another aspect of us.