Confused in Smoothing a signal in the Frequency domain
1) Is this a theoretically accepted method to smooth data in DFT domain or only applies in time domain ?


Sort of. It certainly can be done this way. Doing it directly in the DFT (instead of the PSD) is risky since it's a complex number you can get a lot of cancellation if the phase is fluctuating a lot. 

You also need to decide how you manage the "edges": do you do circular or linear convolution


  2) Are there different methods to smooth DFT data?


Yes. There are as many methods as there are different sets of requirements and application. You plotted your data on a log frequency scale, so you may be better off with "1/Nth octave smoothing algorithm"